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On Wednesday, July 18, after the markets closed, CYS Investments (CYS) reported its financial results for the second quarter of 2012. The company reported GAAP net income of $101.7 million, or $0.87 per share, compared to $69.1 million, or $0.66 per share, in Q1 of 2012. CYS reported its Q2 core earnings were $44.8 million, or $0.38 per share, compared to $41.9 million, or $0.39 per diluted share, in the first quarter of 2012.

CYS is an agency mREIT that holds a portfolio composed of mortgages that are backed by federal agencies. Other well-known agency mREITs include American Capital Agency Corp (AGNC), Annaly Capital Management (NLY), Capstead Mortgage (CMO) and Hatteras Financial (HTS). CYS is the first of these agency mREITs to report earnings for Q2, with the others slated to report in the next two weeks.

CYS' book value per share at the end of the second quarter was $13.52, compared to $13.14 at the end of the first quarter. This was about a 3.85 percent increase in net asset value per share. Shares of CYS have appreciated by 6.42 percent, or $0.84, since the end of the first quarter, while also paying a $0.50 dividend in late June. See a performance chart for CYS since the end of Q1: (click to enlarge)

CYS included that it had a constant prepayment rate of approximately 18.1% and that its portfolio recognized a net amortization of $22.7 in premium within the Q2. During the first quarter, CYS had a constant prepayment rate of approximately 17.2% and net amortization of $16.9 million in premium.

CYS noted that the increase in prepayments and repayments occurred due to a further decrease in mortgage interest rates during Q2. CYS's leverage rate at the end of the quarter was 7.6x and its spread, or the margin between CYS' borrowing costs and the yield its holdings generate was 1.71% percent, compared to 1.88% during the first quarter. Lower leverage and a lower spreads indicate an increased likelihood of a dividend reduction. CYS has paid a $0.50 quarterly dividend for the last three quarters.

Last week, CYS announced a secondary offering of 40 million shares. The offering closed this week, including an over-allotment option that increased the offering size to 46 million. AGNC also announced a large secondary earlier this week and other agency mREIT secondaries may be forthcoming within July. CYS' secondary was priced at $13.70 per share, for total net proceeds of approximately $622 million after commissions and expenses. CYS will use the proceeds to re-leverage up CYS' portfolio.

Both CYS and AGNC noted increases in agency prepayments during Q2. This should be broadly expected, given the significant reduction to interest rates over the last few months. Despite the strong performance of fixed income products during the second quarter, and especially of U.S Treasuries and agency-backed debt, rising prepayments can cash out holders of agency RMBSs at a loss. The agencies then issue new paper at the lower current rates. This prepayment risk is one of the most misunderstood risks facing agency mREITs, though it is also an inevitability for which most have attempted to brace themselves.

Such prepayments can occur due to borrower refinancing or the backing agency calling the security. Like a bond, these securities go up in value as interest rates decline. Unfortunately for the holders, most outstanding agency RMBSs are now trading at a premium to par or call price, meaning that a prepayment will not only take away the security from the mREIT, but that the portfolio will also lose the difference between the present market price and the prepayment price. When a mREIT sustains prepayments, it must then buy new lower yielding paper or already existing paper that might have a slightly superior yield to new RMBSs, but that also carries new prepayment risk due to the premium that is built into its market price.

Given the information received thus far from AGNC and CYS, it should be expected that other agency mREITs will also report rising rates of prepayment, and probably reduced leverage rates that were caused by those prepayments. Many will also probably report reduced spreads. All of this may require some other agency mREITs to institute secondary offerings within the third quarter of 2012, and possibly within the next two weeks, before reporting their earnings. This trend indicates that agency mREITs and their dividends could be under pressure in the second half of 2012.

Source: CYS Investments' Q2 Earnings: Rising Prepayments And Narrowing Spreads