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Summary

  • Move to increase exposure to high yield agency MBS will improve asset portfolio yield and net interest spread.
  • Increase in swaps exposure will provide better cash flow hedge for CYS.
  • Repositioning of investment and hedge portfolio will protect book value and portend well for valuations.

Interest rate volatility negatively affected book values and net spreads earned by of mortgage REITs (mREITs) in 2013. Since the beginning of 2014, treasury yields have stayed relatively stable, which have positively affected the book values and performances of mREITs. Moreover, mREITs are efficiently repositioning their portfolios to protect book values. Also, moving forward, a stable Fed Fund rate, until the second half of 2015, and a systematic end to the Fed's asset purchases will portend well for the book values of mREITs. I am bullish on CYS Investments (NYSE:CYS); consistent with the current yield environment, the company has been taking the right steps by repositioning its portfolio. Also, the company has low leverage and a high level of liquidity, which it could use to reconstruct agency MBS portfolio as opportunities arise, as the Fed continues to taper its asset purchases. The company offers a high dividend yield of 14.50% and recently increased its share repurchase authorization, which will positively affect its EPS in the future.

Financial Performance

The company has been reporting better-than-expected financial performance in recent quarters, despite the challenging industry conditions. CYS reported core earnings plus a drop income of $0.33 per share for 2Q14, better than the consensus estimates of $0.31. CYS' core EPS for 2Q14 came out to be $0.21 below consensus estimates of $0.25 per share; however, drop income of $0.12 for the quarter was better than the consensus estimates of $0.06, which drove the earnings beat. The higher-than-expected portion of the forward settling purchases positively affected the drop income for the quarter. Also, the company's book value increased by 6.5% quarter-over-quarter to $10.31 per share.

However, due to the increase in prepayment speed and as the company increased its exposure to U.S. treasuries during 2Q14, its investment portfolio yield dropped from 2.85% in 1Q14 to 2.67%. CYS' CPR, which measures prepayment speed, increased from 5.6% in 1Q14 to 7.6% in 2Q14. Also, premium amortization increased to $11.1 million in the quarter.

Portfolio Repositioning
In the current industry environment, CYS has been consistently changing the composition of its investment portfolio. In 2Q14, the company increased its gross investment portfolio to $14.20 billion, up 6.7% quarter-over-quarter. In 2Q14, CYS increased its exposure to U.S. treasuries, as the company anticipated treasury yields to be volatile. U.S. treasuries comprised approximately 14.4% of CYS's investment portfolio by the end of 2Q14, as compared to 11.6% by the end of 1Q14. Also, the company increased its exposure to 30-Year MBS during the quarter. The following chart shows the portfolio composition for CYS by the end of 1Q14 and 2Q14.
(click to enlarge)
Source: Company Reports

Since the end of 2Q14, in efforts to improve its investment portfolio yield in a relatively stable treasury yield environment, the company has sold more than 50% of the $2 billion U.S. treasuries it owned at the end of 2Q14, and purchased approximately $1.4 billion worth of agency MBS. In July last month, MBS prices dropped as longer term rates have dropped slightly and rates for 2-year to 7-year securities have increased. In the coming quarters, I believe the company's investment portfolio yield will increase as CYS has been increasing its exposure to high yield agency MBS.

Also, CYS changed its hedging portfolio during 2Q14 to lower its overall rate risk. The company's overall composition of hedging portfolio changed from $5.8 billion in swaps and $3.9 billion in caps in 1Q14 to $7.25 billion and $2.5 billion, respectively. The increase in the swaps exposure will provide better cash flow hedge to CYS, as compared to caps, if the interest rate increases.

Dividends and Share Repurchases

The company currently offers a high dividend yield of 14.5%. Dividends offered by the company are backed by its total EPS. CYS' dividend payout ratio is expected to stay in a range of 85%-to-100% in the coming quarters. The following table shows the dividend per share, total EPS, payout ratio and book value per share of CYS for the last four quarters.


3Q 2013

4Q 2013

1Q2014

2Q 2014

Dividends Per Share (Quarterly)

$0.34

$0.32

$0.32

$0.32

Total EPS (Core + Drop)

$0.36

$0.38

$0.35

$0.33

Dividend Payout (% of Total EPS)

95%

84%

91%

97%

Book Value Per Share

$10.10

$9.24

$9.68

$10.31

Source: Company Reports and Calculations

The company did not repurchase any shares in 1H2014; however, CYS did increase its current share authorization from $134 million to $250 million. As the stock trades at a discount, approximately 90% to book value, potential share repurchases will positively affect its EPS growth.

Conclusion
In the prevailing industry conditions, where interest rates are stable, CYS has been taking the right measures by increasing its agency MBS exposure. Increasing exposure to high yield agency MBS will improve its asset portfolio yield and net interest spread. Also, the increase in swaps exposure will provide better cash flow hedge for CYS. The repositioning of investment and hedge portfolio will protect book value and portend well for CYS' valuations. Moreover, the company offers a high and sustainable dividend yield of 14.5%. Due to the aforementioned factors, I am bullish on CYS.

Source: CYS Takes The Right Steps