Cypress Sharpridge Investments (CYS) is among one of our favored mortgage REITs. The company offers a sufficiently attractive and sustainable dividend yield of 14%, at a time when 10-year treasuries are offering only 1.65%. The company, with an 8.7% price appreciation since the beginning of the year, is trading at cheap multiples, which supports our bullish stance. The management at CYS Investment has constructed the company's portfolio in such a way that CYS is likely to keep rewarding investors in terms of both growth in share price and a dividend hike. With widespread expectations of another round of quantitative easing (QE3), and the upward momentum that the company presents, we recommend investors buy the stock. Of the 16 sell side analysts that cover the stock, only one has a sell rating.
CYS Investments, a mid-cap mortgage real estate investment trust (REIT) with a market capitalization of $2.4 billion, operates in the U.S. financial sector and seeks to invest exclusively in residential mortgage backed securities (MBS), as well as the interest and principal payments that are guaranteed by any government-sponsored entity (agency). Part of the company's investment portfolio is also invested in U.S. treasuries. The company's investments in agency securities consist of fixed rate, adjustable rate and hybrid securities. The company classifies those investments as hybrid for which interest payments have a fixed initial period, and are thereafter reset at regular intervals. The company funds its asset portfolio using short-term borrowings (repurchase agreements) and earns an interest rate spread between the interest that the company earns on its interest yielding assets and the interest it pays on its interest bearing liabilities.
Asset And Liability Compositions
The portfolio of investment securities that the company possessed at the end of the second quarter of the current year touched $14.16 billion, as compared to $9.46 billion in the linked quarter. This is a surge of 50% in one quarter. Approximately 78% of the portfolio constitutes fixed rate mortgage securities, while the remaining consists of hybrid agency investments. Of the 78% fixed rate mortgage securities, 61% have a 15-year maturity. The larger proportion of fixed rate securities with a longer maturity increases the company's exposure to interest rates. According to the sensitivity analysis provided by the company in its SEC filings, a 25bps decrease in interest rates will lead to a 0.33% increase in the fair value of the assets portfolio. For a 50bps decline in the general interest rates, a 0.43% increase in the fair value of the assets will be expected. This is compared to a decrease in the fair value of the assets of Armour Residential (ARR) of 1.39%. Armour Residential is another dividend-paying mortgage REIT with a market cap that is similar to CYS Investment.
Repurchase agreements with a weighted average maturity of just over 27 days are used to fund the company's investment portfolio; these surged 24% over the linked quarter to reach $9.76 billion from $7.88 billion. In order to reduce the counterparty risk, CYS has limited exposure to any single counterparty, and has diversified its exposure across 25 counterparties.
Asset Yields, Cost of Funds and Net Interest Margin for Most Recent Quarter
Yields that the company earned on its interest yielding assets dropped a significant 75bps, owing to the stubbornly low interest rate environment. However, unlike most of its competitors, CYS Investments seems to have benefited at the same time from this low interest rate environment. This we say after looking at the company's cost of funds, which dipped 23bps to 0.91% during the second quarter as compared to the first quarter of the current year.
The decreased cost of funds for CYS, however, did not completely offset the impact of the decreased asset yields, and resulted in a 52bps decline in the net interest spread that the company earned.
Operating Results of Most Recent Quarter
Despite the record low interest rate environment, and the company's heavy reliance on interest income to make money, CYS posted a surge of 8.8% in interest income and reached $70.4 million at the end of 2Q2012. This surge occurred largely due to an increase in the mortgage investments held by the company, partially offset by a decline in the asset yields that the company earned during the second quarter.
Interest expense during the most recent quarter doubled to $9 million from $4.5 million in the linked quarter. Despite a decrease in the cost of funds, as mentioned above, the surge in interest expense was largely associated to an increase in the amount of borrowings made under the repurchase agreements to fund the increase in investment securities.
Operating expense for 2Q2012 jumped by 8% over the prior quarter to $5.3 million. However, when looked at as a percentage of total assets, expenses decreased as compared to the previous quarter. The company reported a bottom line of $102 million in the second quarter, against $99.4 million in the prior quarter. According to the disclosures made by the company in its SEC filings, a 25bps decline in the prevailing interest rates will lead to a 3.87% increase in the bottom line of the company. A 50bps decrease in the current interest rates will result in a 7.75% increase in the projected net income. As opposed to this, a similar decrease in the interest rates will lead to a 2.9% decline in the projected net income of ARR.
The company is following a strict leverage policy, as the quarter end leverage ratio for the past one year remained 7.6 times. The company is moderately levered when compared to 8.9 times for Armour Residential and 8.6 times for Capstead Mortgage (CMO).
In the event of non-existent interest rates in the U.S., mREITs are being focused on as they have been benefiting from cheap borrowing costs, and have continued to offer sufficiently attractive dividend yields for investors looking for regular dividend income. CYS Investments is no exception, and offers one of the highest dividends in the Mortgage RIETs Industry. Its dividend yield of 14% is considered to be sustainable, making it more attractive for investors looking for dividend income. This we say after comparing average quarterly net income over the past five quarters, with the average quarterly dividend paid over the same time period. On average, the company made $82 million in net income per quarter over the past five quarters, while it paid $49 million in shareholder distributions. During the most recent quarter, the company paid a quarterly dividend of $58 million against net earnings of $102 million. This demonstrates the company's ability to continue dividends in the foreseeable future.
The company's stock is trading at cheap valuations when compared to its peers in the Mortgage Industry. The stock trades at a premium of 6% to its book value. When compared to this, Capstead Mortgage and American Capital Agency (AGNC), CYS Investment's competitors, are trading at a premium of 8% and 18%, respectively. MFA Financials (MFA) trades at the same premium to book value as CYS.
Ben Bernanke, the chairman of the Federal Reserve Bank, has been favoring the mREITs Industry by keeping interest rates to a low 0.25% since 2008. The bank has further shown its resolve not to raise interest rates until 2014. These mREITs have enjoyed cheap borrowing costs due to this low interest rate environment, which is why their YTD performance has reached as high as 24%. Most of the mortgage REITs are trading in proximity to their 52-week high. The Fed has implemented certain programs since 2008 to stimulate the economy, including quantitative easing, Operation Twist, and its maturity extension program. However, the U.S. economy is showing no signs of respite, raising the possibilities of another round of quantitative easing (QE3). There are widespread expectations that the Federal Reserve Bank will flex its muscles to provide a stimulus to the sluggish U.S. economy. However, the impact of such a step on the growth of the U.S. economy will be limited, as we believe that with each step, the impact of stimulating the economy will diminish. Even if the impact is not diminished, it will bring down interest rates, and as discussed above, CYS is one of the mREITs that will benefit from this decrease. Both interest income and fair value of the assets portfolio for some of its aforementioned competitors will decrease, giving it a competitive edge over its peers.
Click here to find out about the interest rate sensitivities of the interest income and assets portfolio of MFA Financials, Armour Residential, Two Harbors and Invesco Mortgage Capital. Detailed reports on American Capital Agency and Annaly Capital can also be viewed.
Based on the above analysis, we recommend our investors to buy CYS. Investors can expect a hike in dividends and share price appreciation if interest rates decrease further, as a result of another round of quantitative easing (QE3).