CYS Investments Inc. (CYS) announced Q2 earnings results on the 17th of July after the closing bell. CYS is the first mREIT to report the much anticipated Q2 earnings. The market has responded by a drop on the 18th of July in CYS of about 4% before recovering later in the day to end 1 1/2% lower. Below is the five day chart.
This article will attempt to give you some takeaways from the earnings report to understand what it does and does not mean for CYS and the mREIT market.
CYS lost $2.67 or 20.7% of their book value in Q2, which dropped from $12.87 to $10.20. This loss was due to the value of their Mortgage Backed Securities (MBS) holdings going down. CYS had a realized loss of $211.4 million, meaning they sold some of their MBS at a loss. Their unrealized loss was $444.9 million, meaning the value of the MBS they continue to hold went down by that much. In Q2 interest rates on long term bonds spiked. The 10 year Treasury bond yields increased from 1.83% to 2.49%. mREITs attempt to hedge against interest rate spikes. CYS uses swaps and interest rate cap contracts to hedge against interest rate spikes. These holdings gained $215.5 million in value in Q2, which covered 32.8% of their losses.
The focus recently has been on how mREITs hedges have performed in the face of large MBS value declines in Q2. Short duration swaps did not perform as well as longer duration swaps in Q2 and CYS's swaps were all under 6 years in duration. CYS's caps did a little better as they were longer duration (up to 9 years). CYS mentioned that caps are good for hedging against negative convexity because you can lock them in for a long time while swaptions roll over much more frequently and end up costing more as rates rise.
During the conference call, CYS was repeatedly asked why their swaps weren't longer duration and if they planned on changing that in the future, especially because they increased their holdings of 30 year fixed MBS, which have a longer duration and need longer swaps to counter any drop in value. CYS responded by saying the duration of 30 year fixed MBS turns out to be about 5 years and so that's how long their swaps are. They also seemed to think that interest rates were not going to rise as fast as they did in Q2 again. Their words were: "To have two quarters in a row like that would be pretty unusual" and "it's a low probability event for them to behave like this again" and "the market has priced in most of the taper". They said to manage duration they would just de-leverage instead of changing their swaps (they did de-leverage slightly in Q2 from 7.8x to 7.5x). I don't agree that the taper is mostly priced in. I think a taper announcement would drive MBS down again, but only the event happening will tell who is right on this one. My opinion is based on recent market volatility, they have 30 years experience dealing with rate movements.
CYS increased their percentages of 30 year fixed MBS (45% from 31%) and reduced their exposure to 15 year fixed MBS (35% from 46%). This likely due to their statments on the 5th of June that they were buying up new higher coupon MBS in response to the rise in rates. MBS values have dropped since then and their new purchases had a drop in value. Spreads did increase for CYS in Q2 from 1.16% to 1.36% and their dividend increased from .32 in Q1 to .34 in Q2. Spread earnings should increase as time goes on. CYS stated that they get $600 - $700 million each quarter from the run-off of their portfolio that they can reinvest at the higher spreads.
CYS trades at a 14% discount to book despite the fact that Q3 so far has been relatively flat as far as rates go, and CYS said their BV hasn't change materially since Q2 end. CYS has historically traded around BV. Below is a price to book value chart. (the two plateaus are errors) Current pricing reflects a discount to where CYS usually trades, likely due to continued fears that the rate volatility will continue. Investors may also be discontent about Q2 earnings and CYS's positioning for Q3.
Repurchase agreement (borrowing) rates haven't increased for CYS and they maintained enough liquidity to meet margin calls. They said: "Our excess liquidity was about 65% of the net asset to the Company. This liquidity is the life blood that helps the Company get through storms and be in a position to take advantage of better investing environments on the other side. Liquidity is the key and we want to be the most lender friendly company around because it's the borrower that makes this thing go." mREITs have faced funding crisis in the past, but the fear of this happening again in the near future I think is overblown.
Application to rest of mREITs
What does all this mean for the rest of the mREIT space? CYS hedges did not contain a large percentage of longer duration swaps like many of its peers do, so you shouldn't equate their hedge performance across the mREIT space. The following chart compares mREIT long dated swap positions for CYS at the end of Q2 vs other mREITs as reported at the end of Q1 or during Q2.
|Stock||% Agency MBS holdings covered by 5 year or longer swaps|
|TWO||40.6% (roughly, they used a 4+ year category for swaps, from which I subtracted 25% to get this number)|
Many mREIT hedges will do better than CYS because their hedges are longer duration and/or covered a higher percentage of their investments. Management at other mREITs may have sold less or more of their MBS, and most likely did not re-arrange into more 30 year fixed MBS.
CYS also is a slightly different mREIT in that it has the largest percentage exposure to the 15 year fixed MBS market behind NYMT. Most mREITs have less exposure to the 15 year market and more 30 year fixed. That insulated CYS from some of the larger downside seen in the 30 year fixed market. 30 year fixed Fannie MBS 3.5% coupon went from 106.25 to 101.44 in Q2, while 15 year fixed Fannie MBS 3.0% coupon went from 105.31 to 102.78 in Q2. (from Mortgage News Daily) However, the hedges are different in other mREITs and usually of longer duration and likely offset losses much better than CYS was able to.
I believe the recent rate volatility will cause a divergence in strategy by the mREITs. I think CYS went for the higher spreads to get that narrative going early and try to improve investor sentiment despite the BV hits. Other mREITs will take a defensive approach with reduced leverage and increased swaps and swaptions that could delay the type of dividend increases we saw in CYS and possibly lead to dividend decreases in order to obtain BV protection if rates increase. We have already seen dividend decreases in AGNC, NLY, TWO, and MTGE.
An investor can look at hedging positions reported at Q1 end and during Q2, statements during the quarter, and MBS values to compare mREITs before earnings releases, but its likely there was some significant repositioning that will fuddle with your predictions. Once the rest of the earnings reports come in, a picture of losses and positioning for the future allow a much better comparison of mREITs and how they will fare for the rest of the year depending on your interest rate outlook. The ending of the uncertainty could bring a lot of buyers if the results are better than what the market is pricing in right now.
Additional disclosure: I am long MORL, which includes CYS, AGNC, NLY, ARR in its index
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