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With most banks paying less than 1% interest, and many stocks sporting dividend yields in the low single digits, CYS Investments (NYSE:CYS) looks very attractive with its 14% dividend yield. But just how safe is that yield?

What is CYS Investments?

CYS Investments is a specialty finance company that is taxed like a real estate investment trust (REIT), meaning it must distribute at least 90% of its earnings to shareholders in the form of dividends. And while most REITs invest in physical real estate, CYS is a mortgage REIT that uses leverage to invest in residential mortgage pass-through securities, whose principal and interest payments are guaranteed by government groups like Fannie Mae, Freddie Mac and Ginnie Mae. This gives investors some measure of safety, but then again, the housing bubble and resulting housing and financial crisis have shown that residential properties are not always the safest investments.

CYS Investments is not the only high yielding mortgage REIT available to investors seeking income. Annaly Capital Management (NYSE:NLY), with a market cap of nearly $17 billion and a 13% dividend yield, is another mortgage REIT behemoth. It has two subsidiaries, Chimera Investment (NYSE:CIM) with a dividend yield of around 15.5%, and Crexus Investment (NYSE:CXS), with a dividend yield approaching 11%.

Other mortgage REITs worth noting include American Capital Agency (NASDAQ:AGNC), which has a yield of nearly 15%, ARMOUR Residential REIT (NYSE:ARR), which currently yields just over 16%, Hatteras Financial (NYSE:HTS), currently yielding around 12.5%, MFA Financial (NYSE:MFA), nearing 12%, and Two Harbors Investment (NYSE:TWO), with a yield of 14.5%.

How Mortgage REITs Generate Those Spectacular Yields

The above mentioned yields have attracted a considerable amount of attention from income starved investors suffering in the current near zero interest rate environment, but investors need to also understand how mortgage REITs are able to generate such yields, and the risks involved.

Mortgage REITs generate income from the spread between the interest earned off their mortgages or other investments they hold, and the borrowing costs incurred in order to acquire those investments. To further augment those returns, mortgage REITs often use leverage. This means mortgage REITs borrow at lower short-term lending rates in order to go long, and that means they will be impacted by any future rise in interest rates. It is inevitable that interest rates will not remain at near zero forever.

That brings me to another key risk faced by mortgage REITs - rising conditional prepayment rates (CPRs). A conditional prepayment rate is the percentage of principal that is prepaid on an annualized basis. This forces the mortgage REIT to reinvest in new mortgages that come with lower rates. Ultimately, and when there are enough newer mortgages in the mortgage REIT portfolio, it won't be able to pay the same high dividend because the income being generated is lower. Moreover, a rising conditional prepayment rate will only mean that the inevitable fall in dividends or dividend yield will come earlier.

Does CYS Investments Belong in Your Portfolio?

Should you consider CYS as part of the income generating portion of your portfolio? As mentioned earlier, CYS is investing in residential mortgage pass-through securities guaranteed by government groups, meaning its portfolio is not too opaque like the portfolios of some of its peers.

CYS also reported a prepayment rate of approximately 18.1% in its portfolio last quarter, and prepayment rates have been rising (up from 17.2% for the first quarter). But that should not be a surprise to anyone, as low interest rates have encouraged many homeowners to refinance.

In addition, it should be noted that while CYS was trading at around $14 per share near the end of August, its book value per share, according to Yahoo Finance, is $13.52. Its forward dividend is around $2 per share, equating to a 14% yield. That means new investors buying CYS right now will not be paying much of a premium to obtain shares. Barring any major stock moves in either direction, they will start to earn a premium after their first dividend payment.

But, investors should note that in mid-July, CYS had a secondary common stock offering of 46,000,000 shares, at $13.70 per share, to raise $622.2 million, bringing the total number of shares outstanding to 166,603,668. A quick review of CYS' press releases posted on its website reveals another offering back in February for 28,750,000 shares, and an offering back in February 2011 for 23,000,000 shares. This is in addition to three more offerings in 2010. CYS went public in June 2009.

Secondary offerings will dilute existing shareholders, but that does not mean existing shareholders automatically end up as losers. If a company puts the money to good use, everyone will come out as a winner. Nevertheless, existing investors in CYS should be concerned that the company might start making secondary share offerings a regular habit, as they will tend to hold down share prices. On the other hand, CYS' share price largely bounced back after the last secondary offering. But, that does not mean it will continue to bounce back if the company decides to do more offerings.

The Final Verdict: CYS Investments

If you need to have income and you are not concerned that the income may fluctuate considerably, then mortgage REITs like CYS should be considered as a small allocation in your portfolio. Just be aware that the interest rate environment may start to change late in 2013 or early 2014, and that the current juicy yields of most mortgage REITs are far from a sure thing for the long-term.

New and existing investors should be concerned about secondary offerings becoming a regular occurrence, but buying right after any new offering that causes a dip might be a smart move, should the stock quickly bounce back. Unlike some of the other mortgage REITs out there, CYS is not trading at a huge premium, and it is not investing in opaque mortgage related instruments, meaning the risks faced by investors is lower. There is probably still some value along with income to be had by new investors.

Source: CYS: A Safer mREIT?