How Did CYS Investments Boost Book Value Per Share?

| About: CYS Investments, (CYS)

Summary

While most mREITs are suffering with weaker book values, CYS Investments looks stronger.

There is no magic here; I’m simply able to run the math and assess the portfolio.

Investors that rely on “last reported book value” and treat announcements as surprises might as well play Three-Card Monte.

CYS Investments ((NYSE:CYS)) is perpetually one of my favorite mREITs. While I've been concerned about book values declining and discounts to book value shrinking, I see CYS mREITs having a bit of a different quarter. While I'm still very concerned about the health of the sector, I think CYS Investments is one of the more attractively priced candidates. That isn't the same as saying that prices are downright attractive, but this is a potential option for investors that want to look at pair trades. The book value for CYS Investments looks much stronger than peers.

Book Value Estimates

I want to start with the estimates and then I'll work through explaining how I got there. This should resemble a book that starts with telling you about a scene near the end. Before I demonstrate the calculations, I want to point out that these numbers were as of 03/17/2016 so no dividend had been paid yet. The shares went ex-dividend on 03/18/2016 so the book value should have declined by $.26 on that date absent any other changes in rates.

In analyzing CYS Investments I want to start with assessing the change in the fair value of the assets. I can do that by evaluating their exposure to different types of agency MBS. For instance, I want to assess how much of the portfolio is in the 15 year fixed rate securities. Within that I want to know how much is in pools with a coupon rate of 2.5, 3.0, 3.5, and so on. Once I know how large these positions were and how much those positions moved up or down since the quarter began I can create estimates for the gain or loss on MBS.

The same technique is used in assessing the hedges. I look at the movement in the rates and calculate the expected gain or loss. The process isn't perfect in either regard and mREITs will often treat both assets and hedges as "Level 2" valuations which means management can get some great guidance by market values for similar assets but the numbers won't be perfect. Since management will always have more information than analysts, their numbers should always be more accurate. The advantage that a good analyst offers is that they can provide information that is substantially faster. The goal isn't to get values nailed down precisely; I just want to get a very solid estimate prepared quickly.

Some investors are happy relying on the discount to a book value that is 2 months, 3 months, or 4 months out of date. Those numbers should be seen only as a rough starting point. Making a decision to buy or sell on them is a quick way to lose money.

Three-Card Monte

Trying to buy and sell mREITs on discount to book value figures that are out of date when other market competitors are running simulations to get new values is akin to playing Three-Card Monte. Investors are making a bet with weak information against traders with superior information. How much better would you feel with a professional magician standing beside you and pointing to one of the cards?

Pointing to a Card

In a recent piece on ARMOUR Residential REIT ((NYSE:ARR)), I encountered the challenge the professional magician might encounter. No matter how much they may say that a fake throw occurred on the 7th shuffle with the left hand, there will be someone sure that the magician must be wrong.

Using Replay

One advantage for an analyst that the magician wouldn't have is the ability to use replay in demonstrating the movements. Since I'm estimating that the hedge loss is equal to $95,996 (in thousands), allow me to demonstrate how it happened.

The hedges are primarily swaps, but there are also some interest rate caps. Since management of CYS Investments tries to be transparent (a great quality), they provide some great slides.

Click to enlarge

Since we have an estimate of the duration of the positions and a few different batches, we can get a feel for how far out on the curve the swaps are positioned. That is important because the changes in rates are not uniform across the curve:

Rates decreased since the end of Q4 and the green lines easily demonstrate that the drop in rates was larger at the longer end of the yield curve than the short end of the yield curve.

Seeing the shape has some important implications. It demonstrates that the yield curve is getting flatter and it helps me evaluate the different hedge positions. Since I know the movements for each position and I know how many days have occurred, I can calculate the expected loss and adjust for the change in the duration of the swaps.

Discounts

Using the March 17th value the discount to book value would be 19.9%. Adjust for the dividend and the discount would fall to 17.73%. This puts the discount at a fairly similar level to American Capital Agency Corp. ((NASDAQ:AGNC)) and makes it larger than my estimate for ARMOUR Residential REIT. That is simply the case for ARR because of the losses I'm projecting on their swap positions.

Conclusion

The flatter yield curve combined with shrinking discounts pushed me off of my previous bullish stances. When simply assessing the mREITs on relative attractiveness, I think CYS and AGNC are running at fairly similar levels and ARR is less attractive. If the yield curve was steeper or the discounts to book value were larger, I would be bullish.

I still like CYS Investments as an mREIT, but I don't like them as an investment at this price. After assessing discounts for CYS Investments, I can add the common shares to the list of mREITs where I am still waiting for attractive pricing. None of the three mREITs here is currently meeting my criteria for attractive options, though I may consider the preferred shares.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.