CYS Investments (NYSE:CYS) usually sets the expectations for mREITs in earnings seasons. This season that trend holds. Remember CYS manages a portfolio that invests in various types of agency mortgage-backed securities. It has some diversification which I like because it also is involved in commercial mortgage loans and other commercial real estate debt, commercial mortgage-backed securities, and other commercial real estate-related assets. Now that it has just reported earnings I want to examine the results to understand where the bar has been set.
Let us get right into the earnings and key metrics we look for in mortgage real estate investment trusts. Let me say that the company just missed earnings expectations that I had. I was looking for $0.28 per share in core plus drop income; more on this in a moment. Further net interest income fell year-over-year. The company saw $63.5 million in net interest income for Q1 2016. It also fell quarter-over-quarter. Last quarter net income was $71.8 million. Further, the present quarter is lower than the $71.7 million in Q3 and $70.3 million in Q2. So that is a disappointment.
What we care about, of course, is not net income, but core income. It's a better measure of the ability to cover the dividend. Well, the new dividend of $0.26 was covered when we look to core income. Core earnings plus drop income came in at $40.3 million, or $0.27 per share. This is down from the $0.29 per share last quarter. It is important to note that we see that this was made up of core earnings of $34 million, or $0.22 per share. Thus, drop income was $6.3 million, or $0.05 per share.
The key metrics I harp on played a big role in these earnings figures. First, total interest income decreased to $81.5 million, down from $85.8 million in Q4 2015. This fell because of lower average settled debt securities. This was a shame because there was a higher yield on the debt securities.
What is most interesting is that performance was slightly less than my expectations despite the fact that the company experienced lower prepayments in Q1 2016. Recall that this is a decline that I predicted. I had stated that prepayments would subside into the end of the year in 2015 and early 2016 so I am pleased to see this. Now there has been some refinancing activity over the last few months so the constant prepayment rate could be an issue later this year once again, but here in Q1, the constant prepayment rate dropped to 7.6% from 8.1% in Q4 and down from 10.2% in Q3 2015. It is also worth noting that this is down from 13% in Q2 2015. This played a strong role in helping earnings cover the now smaller dividend.
I will also point out that the average cost of funds in Q1 2016 rose to 0.68% compared to 0.49% Q4 2015. That rise caught me slightly by surprise however it was not as impactful due to the yields rising. But you do the math. A higher yield on investments needs to outpace the increase in cost of funds to benefit the spread. Thankfully the increased in yields did indeed outpace the increase in costs of funds. The net interest rate spread, net of hedge including drop income, was 1.45% for Q1 2016, up 2 basis points compared to 1.43% in Q4 2015 and is flat from one year ago.
With the motion in rates, the value of some of the holdings were down a bit, but it was a mostly stable quarter in this regard. Net of the $0.26 dividend, book value came in at $9.46. So it is one of the first times that book value has risen in some time. It was up $0.10 of 1% from $9.36 to start the quarter. This turn-around puts a stop, for now, to the long and slow blood-letting we have seen in book value and is one reason shares trade at a discount. But compared to the beginning of last year, it is still down heavily. It entered 2015 at almost $11.00. However, there is no denying the environment has improved this quarter.
Look compared to recent history, this quarter was decent. Even though it covered its dividend and saw some improvements, it's nothing to write home about. Simple as that. As I have said all eyes should be on the constant prepayment rate. That really told the story last year. This quarter, it helped offset lower debt securities. Having a low constant prepayment rate really drives interest income, and in turn the bottom line and dividend coverage. I see this metric potentially ticking up in the summer. Thinking long-term, remember that you need to carefully pick your spots. I think the largest issue is that many readers buy too much at once and don't lay out their entrance and exit plans ahead of time. Under $8.00, I think the name is worth considering, but use caution.
As always, I welcome your comments.
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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.