CYS Investments: My Trigger Finger Is Getting Itchy

| About: CYS Investments, (CYS)

Summary

By tracking the movements across assets and hedges, I’m able to establish estimates for book value for CYS.

CYS Investments is the mREIT that I see gaining book value per share during a quarter that should see most mREITs with a slight decline.

The way swaps are structured allowed CYS Investments to lose less on hedges than peers and sends a higher cost through core earnings.

CYS Investments (NYSE:CYS) remains one of the best mREITs in the market. I dropped my rating from bullish earlier as the curve flattened, but CYS Investments appears to be trading at a larger discount than peers. I'm concerned about future price performance for the sector as a whole, but anyone picking CYS Investments as the mREIT to short would be crazy. Based on my estimates, it has a larger discount and the earnings have been fairly reliable in large part due to using a portfolio of lower rate MBS that are less susceptible to prepayments and focusing on hedging the short part of the yield curve, which reduces the periodic cost of the hedge position.

I expect CYS to perform better than most of the agency mREITs, despite my strong concerns about the sector in general.

Book Value Estimates

These estimates are still somewhat rough, but the simple agency MBS portfolio used by CYS Investments makes it a little easier for modeling its results.

I'm estimating the unrealized fair value loss on its hedge positions, shown below, will run about $.79 per share.

Gains on MBS

The assets did fairly well and provided some nice gains for CYS Investments:

I put a green box around the huge winners. The 15-year 3.0 gained about 1.36% during the quarter and the 30-year 3.5 gained around 1.6%. These positions performed dramatically better than higher rate MBS due to the market expecting prepayment levels to increase significantly and to be a major headwind to asset yields. Since CYS is holding MBS with only moderately high coupons, the premium to book value on those MBS is lower. The beauty of a smaller premium to par value is the reduced impact of prepayments. Even if borrowers prepay the MBS, the loss is significantly smaller.

Higher Rate Swaps

The weighted average rate on swaps for CYS Investments is 1.29%. I ran the positions for the start of the period and determined that a new set of swaps (recognizing all losses and opening new positions) would have driven the cost down to about 1.03% for its hedge portfolio. Of course, it didn't do that and if I see an mREIT using that stunt, it would draw my attention. The important thing I want to point out in this regard, though, is that the net interest payments on swaps are about $5 million higher than they would be on new swaps. This cost gets passed through Core EPS instead of being an unrealized loss on swaps. It holds Core EPS down by about $.03 per share. This is simply an accounting impact, but it is still favorable for book value when most of Core EPS is paid out in the dividend.

My estimate on Core EPS here is a very rough estimate. I haven't gone through to double check positions, yields, and costs to establish new earnings estimates. The focus of this piece is strictly book value estimation.

As of March 31st, the closing price of $8.14 is a 15.33% discount to my estimate of unreported book value. This is larger than average for the peer group I use in assessing CYS Investments.

Conclusion

The flatter yield curve remains a concern. Coupling the yield curve with smaller discounts across the sector puts an end to my bullish views in absolute terms. I still see CYS Investments as having better performance than other agency mREITs and trading at a slightly larger discount.

If shares were in the range of $7.00 to $7.20, I would feel heavily bullish. Based on my current estimates of book value, that would provide around a 25% to 27% discount. Such a discount would be enough to more than offset the challenges facing the industry and push me into seeing this as a very solid buy. I don't expect it to happen soon, but I'm keeping cash on hand and would be ready if it did.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PREFERRED SHARES OF ANY MREIT over 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. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. 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.