CYS Investments (NYSE:CYS) reported an excellent second quarter. The company covered the dividend of $0.25 with Core EPS of $0.26. Despite covering the dividend, they elected to trim it during the second quarter. Prior to the second quarter, it was $0.26 per quarter (trimmed to $0.25 per quarter). Book value also increased slightly during the quarter and came in at $9.55 per share. An increase of $0.09 from 3 months ago. That is fairly close to my estimates, coming in $0.02 shy of my projections.
The chart below shows my projections, prepared on 07/01/2016:
I was off by $0.02, despite Core EPS coming in at the projected $0.26 per share. That is close enough to be happy with the projections. Note that since the projection was from 07/01/2016, the share price is dated back to 07/01/2016 as well.
How Did CYS Investments Gain Book Value Again?
CYS is building up book value while paying out a very respectable dividend. That wouldn't be such a surprise if the mREIT were heavily invested in credit sensitive assets. During the year, credit sensitive assets have been on a tear. On the other hand, agency RMBS have been a harder area to deliver positive returns because the prepayment risk limits the price appreciation on the bonds.
CYS Investments is running a portfolio designed around the premise of interest rates being lower for longer. The expectation is clearly reflected in their decision to emphasize lower coupon RMBS (lower prepayment risk) and to choose short duration swaps that create a smaller loss in book value when rates fall. Consequently, CYS Investments is able to deliver strong performance as rates decline. If they were using long duration hedges, say 10, 20, or 30-year swaps, they would be losing book value due to the size of the loss on longer duration swaps.
Bringing Back Treasuries
The CEO of CYS Investments is Kevin Grant. He is an exceptionally bright man and I regularly see eye to eye with him macroeconomic predictions. His views are clearly articulated in presentations and earnings calls. His mortgage REIT took on Treasury securities as part of the portfolio. Remember that REIT qualification requires emphasizing real estate. However, an mREIT can still hold a small portion of their portfolio in treasury securities. Since the treasury securities are extremely liquid and provide an excellent store of value, it is possible for the REIT to buy some treasuries, enter repo agreements, and hedge with LIBOR swaps.
There was a time when such a strategy would seem absurd, but in the economy today the rate on LIBOR swaps is materially lower than the rate on treasuries. The difference depends on the duration, but longer duration swaps have shown a materially lower rate. The simple consequence is expecting more interest income than interest expense. Since the spread between Treasuries and LIBOR swaps shrinks as duration decreases, it should be reasonable to expect a net capital gain if the REIT ends the two positions at the same time.
Buying Back Shares
CYS Investments bought back a small amount of shares during the quarter. It was not a major factor. Discounts were smaller and the volume of the buyback was not as extreme as in some quarters. This was a nice thing to see for a slight boost to book value per share but it was nothing extreme.
Management is still calling for rates to be lower for longer. The portfolio reflects those expectations:
The latest figures are in the far right column. The new light blue color reflects the 15-year agency RMBS with a 2.5% coupon. This is indicative of low prepayment risks. CYS Investments is running an agency RMBS portfolio, but they are hedging against the prepayment risk through their choice of low coupon RMBS.
CYS Investments had another solid quarter with book value increasing while Core EPS covered the dividend. The growth in book value is directly attributable to the REIT emphasizing lower coupon RMBS that can appreciate better than high coupon RMBS. The stronger price growth is because the portfolio is inherently designed to reduce the prepayment risk that is inherent to the RMBS structure.
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