CYS Outperformed In 1H 2016: What Is The Outlook For 2H?

| About: CYS Investments, (CYS)


CYS pays an 11.2% annual dividend per common share, after the quarterly dividend cut from $0.26/share in Q1 2016 to $0.25/share in Q2 2016.

The company had Core Earnings plus Drop Income of $38.7 million ($30.7 million in Core Earnings and $8.0 million in Drop Income) - $0.26 per diluted common share.

Book Value rose in Q2 2016 by +$0.09/common share to $9.55/common share.

Hopefully this article will help readers grow their assets.

CYS Investments, Inc. (NYSE:CYS) is a mortgage REIT. It invests in Agency RMBS. These are collateralized by Agency ARMs, Agency Hybrid ARMs and Agency fixed-rate mortgages. When a company can maintain or grow its book value while paying a great dividend, it is a good investment. Admittedly, CYS' book value suffered in 2015. However, it logged a good gain in book value in Q1 2016 of +$0.10 per common share. It logged another good gain in Q2 2016 of +$0.09 per common share. This leaves the book value at $9.55 per share as of Q2E 2016 (up +$0.19 in 1H 2016). CYS also paid a $0.26 per common share dividend in Q1 2016 and a $0.25 per common share dividend in Q2 2015. Yes, that was a dividend cut; but CYS still did better than many other mortgage REITs with regard to its dividend. If you annualize the total return based on the $9.26 per share book value as of December 31, 2015, you get a total annualized return of 15.1%. That is great performance in this highly uncertain market. On top of that CYS is invested in Agency RMBS and US Treasuries, which are backed by the US government. There is little chance of huge losses, especially in a relatively weak economy and consequently low interest rate environment.

The headline numbers above are quite good. Now let's "look under the hood" to try to see if everything is as good as the headline numbers. In Q2 2016 GAAP net income was $51.0 million ($0.34 per diluted common share). Core Earnings plus Drop Income was $38.7 million ($30.7 million in Core Earnings and $8.0 million in Drop Income) - $0.26 per diluted common share ($0.20 Core Earnings and $0.06 Drop Income). Net Interest rate spread, net of hedge, including Drop Income, was 1.36%. Operating expense ratio was 1.36%, down from 1.48% in the prior quarter. The Leverage Ratio was 6.91 to 1 at Q2E 2016 compared to 6.76 to 1 at Q1E 2016. The Constant Prepayment Rate ("CPR") was 12.9%. This was up hugely from 7.6% in Q1 2016. CYS also repurchased 162,548 shares of its common stock at a weighted average price of $7.93 per share for approximately $1.3 million. CYS gained +$0.09/common share in book value in Q2 2016 for a Q2E book value of $9.55 per common share.

The above all sounds good to great; but there were still worries going forward, especially after the positive Brexit vote on June 23, 2016. In other words, Britain's decision to leave the European Union was roughly at the end of Q2 2016, so those results were not hugely affected. Of course, the Brexit may be reversed based on a referendum to reverse the decision. Still, any action in this vein seems likely to be drawn out. A lot of negotiations will have to take place; and getting the EU as a whole to agree to any changes that would make the British public want to remain could be problematic. For instance, it is well known that they do not want to take a huge influx of Middle Eastern immigrants.

On top of that Italy has a referendum vote scheduled for October 2016. Many think that could lead to Italy leaving the EU. Significant changes in national relationships would almost assuredly have near-term negative effects on the EU and British economies (and likely the economies of many of the trade partners). This kind of uncertainty is likely to lead the ECB to try to keep sovereign bond rates down as much as possible in order to provide good liquidity during uncertain times.

The US rates are sure to stay lower upon the same premise. Plus the Fed will tend to be more cautious than it would have. Also the US presidential election is coming up. The government likes the economy to be doing well leading up to that. Of course, the Italian referendum could upset the apple cart. The chart of the 10-year US Treasury Note yield below gives investors a good idea of how the Brexit has affected bond interest rates (yields).

The bottom so far has been 1.36% on July 8, 2016. Notably, this was in Q3 2016. The trend still appears to be downward. We will have to wait to see how low rates actually go. However, they do look destined to go still lower; and the recent big disappointment in the US Q2 GDP Growth estimate of 1.2% (from an expected 2.5%) and the lowering of the Q1 GDP growth number from 1.1% to 0.8% seem sure to encourage lower rates. The above should also tend to discourage the Fed from raising the Fed Funds Rate. This should translate into higher prepayment rates in Q3 2016 and possibly in Q4 2016. That will likely mean lower profits for CYS and other mortgage REITs. It will constrict spreads. Plus the added volatility may push basis spreads wider. Remember the coming October 2016 Italian referendum when you consider this aspect. The above seem likely to hurt profits of Agency mortgage REITs such as CYS.

The table below shows CYS' portfolio as of June 30, 2016.

The charts below show CYS' portfolio changes to adapt to the changes in the overall markets.

As readers can see above, CYS' 30-year MBS have decreased from 54.0% of CYS' portfolio at Q1E 2016 to 46.4% of its portfolio as of Q2E 2016. The 15-year MBS have increased from 42.8% to 44.1%. The US Treasuries holdings have increased from 0.2% to 6.5%. In other words, CYS has gotten much more conservative. Notably, the higher coupon longer dated 30-year Agency RMBS are usually much more likely to be prepaid in this interest rate environment. CYS has reacted appropriately to that; and CYS may do more as Q3 2016 goes on. The new US Treasuries holdings cannot be called at all; and CYS believes its new shorter term, lower coupon RMBS are much more prepayment protected. CYS specifically sold some of its highest priced 30-year RMBS as they were the securities most likely to cause the biggest losses on prepayments (and to be prepaid). Investors will have to wait for more information from the company on any further actions the company plans to take.

To get a better picture, the breakout of the Agency RMBS in the portfolio is in the chart below.

The chart on the left above is from Q2E 2016. The one on the right is from Q1E 2016. As readers can see the big change is in the higher coupon 30-year 4.0% RMBS. They were 20.5% of the portfolio at Q1E 2016. CYS cut this percentage down to 14.2% by Q2E 2016. These are/were the most likely to experience increased prepayments due to the ultra-low 10-year US Treasury Note yield (low interest rates). Lessening the percentage of these higher coupon Agency RMBS should help to prevent CYS from experiencing large prepayment-related book value losses when interest rates start to rise. CYS may make further moves in this line in Q3 2016 and beyond. This shows good management. It shows management is paying close attention to the world economic and bond rate situation.

CYS also exchanged some of its closer to maturity higher coupon hedges for farther from maturity lower coupon hedges. By this change CYS lowered its hedging costs ($2.2B of shorted dated 1.43% swaps for $1.7B of longer dated 1.21% swaps). This is a bit of a gamble; but CYS has been making a lot of correct calls lately. It would be inappropriate to try to second guess management on this move without clear evidence that it is wrong. For now it should allow CYS to earn slightly more in Core Earnings than it would have with higher hedging. The chart below shows CYS' hedging trends.

Note the comment above that the swap net-pay rate decreased in Q2 2016 to 54 bps from 64 bps in Q1 2016. This presents some risk going forward; but management bet the right way again for Q2 2016 at least. Readers probably have to give them some credit for being good. The tables below present CYS' view of the potential losses on various interest rate moves for Q1 and Q2 hedging. They look reasonable, if they are in fact accurate estimates.

CYS also cited a net duration of 0.35 for Q2E 2016. This is quite reasonable. However, duration has not been a great predictor with the high amount of volatility lately, so do not rely overly on this statistic. Mathematically it works better in less volatile times.

The chart and tables below show CYS' recent history of investment gains and/or losses compared to hedging gains and/or losses. The dashed line represents net gains and/or losses.

Considering the above has been accomplished through some very volatile times, CYS' record is quite good. Remember CYS has managed to pay an excellent dividend throughout this period. On a historical basis one would have to say CYS is still a BUY. It may have to lower its dividend yield again in the near future. TBA trades may be more problematic going forward near term; and the net interest rate spread is a worry with ever lower rates. However, CYS' management is showing skill. One can hope that this continues.

The two-year chart of CYS provides some technical direction for a trade/investment.

The chart shows that CYS bottomed at the beginning of 2016. It has since shown a consistently rising trend line. The closing stock price on July 29, 2016, was $8.95/share. This is only about -6.3% below the book value as of June 30, 2016. CYS is becoming closer to fully valued. Yet the market is searching for relatively safe yields. The management of CYS has shown outperforming capability in recent times. This makes CYS a buy. However, the Brexit, the Italian Referendum, the big miss on the US Q2 GDP Growth estimate at 1.2% (2.5% was the expected number) argue that there could be trouble ahead for CYS and mortgage REITs in general. Still those in search of yield have to like CYS' recent record; and that means they could continue to bid the stock price upward. It does pay an 11.2% annual dividend.

With all of the above in mind CYS is a LOW BUY. If a recession seems imminent, I might sell CYS for the short term. Investors will have to decide such things for themselves or they can look for future articles to direct them.

NOTE: Some of the fundamental fiscal information above is from Yahoo Finance.

Good Luck Trading/Investing.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CYS over 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.

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