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Summary

  • Neutral thesis on CYS due to weak growth prospects given its high exposure in agency RMBS.
  • Defensive approach needs to be better managed to tackle interest rate scenario.
  • Company needs to diversify portfolio mix to enhance asset yield.

CYS Investments, Inc (NYSE:CYS) is a specialty finance company that invests in residential mortgage pass through securities. Both interest payments and principal amounts are guaranteed by government-sponsored entities. I am neutral on the company because of its weak growth prospects due to its high exposure in agency RMBS, which I believe has limited opportunities. Furthermore, CYS has adopted a defensive strategy by changing its portfolio mix and is raising its hedge position, which will reduce its net interest spread. However, the company continues to offer an attractive double digit yield, higher than its peers.

Defensive Approach
The company has reduced its 30-year MBS portfolio to $3.3 billion in 1Q'14 from $5.2 billion in 4Q'13. It also added $1.5 billion of treasury securities, which constitute around 12% of the portfolio. Furthermore, CYS has also increased its interest rate swaps and cap position to $9.7 billion, which covers around 97% of repo agreements. Both of the above mentioned approaches were meant to minimize the impact of a rising interest rate and reduce the volatility of book value.

I believe the defensive approach being adopted by the company is not the right strategy because of two reasons. Firstly, I think interest rates will not be volatile because the U.S. economy has started to show signs of a recovery. There are some slacks, and the recovery is slow, but the movement is towards the right direction. Most importantly, the movement in interest rates is becoming predictable and less volatile. Also,10-year treasury rates are down by 14.64% YTD.

In the recent testimony to the Senate Banking Committee, Janet Yellen said the Fed will keep a loose monetary policy until the affects of the financial crisis are completely gone. This means that short term interest rates are not expected to rise in the near future. The Fed chairman has also pointed out that the rise in wages and labor force participation rate could speed up the process of increasing interest rates.

Secondly, this approach will hurt the company's net interest margin and, as a consequence, its core EPS. Asset yield will decrease because the company has moved away from high yielding 30-year MBS to low yielding treasury securities. Moreover, increasing the swap positions will increase the cost of funds.

So I believe the company has overplayed its defensive approach. The Fed has given clear signs of what could stir up the rates in the future. Therefore, the company should closely follow the labor market and plan its defense accordingly. CYS will be reporting second quarter earnings on July 21, 2014. I am expecting earnings to slightly miss analyst expectations due to the lower net spread and high CPR. I am also expecting that the company will reduce its hedge position from 1Q.

Portfolio Diversification
Another discouraging sign is that the company has shown little interest in diversifying its portfolio. When asked about non-agency exposure and mortgage servicing rights in the 1Q earnings call, the company showed no interest at all. CYS did find attractive opportunities in commercial MBS and might add them to the portfolio in the next 6-8 months.

The management has extensively talked about lowering the leverage ratio to 6.32x to take advantage of the cheap agency MBS in the future. In the figure below, I have compared the debt-to-equity ratio of CYS with its peer companies, Hatteras Financial, Corp (NYSE:HTS), Annaly Capital (NYSE:NLY), and American Capital (NASDAQ:AGNC), and ARMOUR Residential (NYSE:ARR). The company's leverage is almost equal to its peers' average and significantly higher than the RMBS giants, NLY and AGNC.

Source: Companies Reports

Dividends and Valuation
Amongst its peers, the company offers the highest yield of 14.50%, which I believe is the major attraction for investors. CYS' quarterly dividends of $0.32 are well covered with $0.35 of core earnings and drop income. I do not expect any significant price appreciation because the stock should trade around 90% of its BVPS.

Conclusion
I believe the company needs to diversify its portfolio mix to enhance its asset yield. Also, CYS needs to better manage its defense approach to tackle the interest rate scenario. However, sustainable double digit yield continues to attract investors.

Source: Sustainable High Dividend Yield Attracts Investors To CYS Despite Worrying Strategies