Time to break down one of the strong REITs. If you have any questions, feel free to ask:
CYS Investments (NYSE:CYS), in the past, was given a strong buy rating by me. Based on current prices and the macroeconomic environment, it has become a Sell. The company still has a strong management team. In the past, CYS predicted a flattening yield curve. The mortgage REIT invests exclusively in agency MBS.
With the prediction of a flattening yield curve, the company was investing in fixed-rate mortgages with lower coupon rates.
Why this strategy? CYS viewed the higher rate securities as a massive risk with a flattening yield curve. As the yield curve flattened, prepayments on loans went up substantially.
The dividend for CYS is temporarily sustainable. The company correctly predicted the flattening of the curve. However, the economic environment for mortgage REITs became significantly worse. Temporarily, CYS will be able to sustain the dividends. This article will show you why it shouldn’t last. Between duration risk and future hedges, the company eventually won’t be able to cover the current dividend rate. My Sell rating is based on CYS having issues over the next several years. It outplayed the other mREITs, but eventually they will have to play in the same pond.
Note (price targets): Green bar before ex-dividend. Purple bar after ex-dividend. Shares are already ex-dividend.
For a reference point throughout this article, these are my price points:
The blue box is when I believed the stock fell way too hard in early 2016. It was then that I gave CYS a Strong Buy rating.
The red box is the recent price of the company. Not only has the price jumped materially, but there’s been a flattening yield curve. The price went up too far, while the mREIT space is facing major economic headwinds. CYS also carries a yield of 11.61%, which is not sustainable long term.
The purple line is where I’d be comfortable upgrading CYS to a buy rating. Note, the price would not have to drop to under $7.35 to be within my Hold range. At $7.87, I’d upgrade the stock to a Hold.
CYS predicted this movement of rates a long time ago. In the Q2 2017 presentation, management tells you about the current investment environment:
First, notice the part underlined in red. The company mentions the flattening yield curve. Then, CYS states how Agency RMBS are doing on a relative basis. The statement was not “Agency RMBS remain attractive.” CYS understands the difficulties mREITs are starting to face. However, the current environment still leaves Agency RMBS as a better option comparatively.
The important part here to notice isn’t the drop from 1.61% to 1.4%. Operating expense ratios will change from quarter to quarter for mREITs. The important piece to note is how low the ratio is. The higher one, 1.61%, is still materially better compared to peers. This is a product of being internally managed. All else held equal, it is always better for a mortgage REIT to be internally managed. I believe external managers bring less value to the table and take more money.
What did management do with the predictions?
CYS locked in a better hedging strategy than its peers. Companies like AGNC Investment Corp. (NASDAQ:AGNC) and Annaly Capital Management (NYSE:NLY) have been hiding their hedging strategy using futures contracts. Futures contracts eat at book value but won’t show up on core EPS. This gives the illusion of the company being able to cover the dividend.
CYS just hedged better than everyone else. There are a few items to note on the hedging:
Before getting into hedges, let’s take a look at the green box and green arrows. The drop from debt securities, at a glance, doesn’t compare with BV per common share. The book value per share is at period end, meaning the value was taken at a specific moment in time. Mortgage REITs investing in fixed securities took a significant hit to book value near the end of 2016.
The debt securities metrics were averaged out over the quarter. This is why the metrics in the big green box seem to fall over two quarters, while the green arrows show a drop-off in only one quarter.
How does a drop-off like this happen when the company hedges?
Short answer: Negative convexity of RMBS
Here’s a chart of what happened:
This loss can be attributed to the massive increase in rates. What was going on during Q4 2016? The Presidential election.
The key word here is massive. Mortgage REITs buy assets and hedge hoping for small incremental changes. Massive changes bring prepayments into play, which creates negative convexity:
After rates go up, there will be less prepayments.
Isn’t that a good thing, CWMF? No, not if rates just saw a massive hike.
Now, instead of a 30-year fixed rate mortgage having an average maturity of 4 years, it’ll be 6. This is bad because now the mortgage REIT has to wait, on average, 6 years instead of 4 years to buy new mortgages at the materially better rate. Sure, your current investment is a little better, but not nearly as good as the new rate.
We can see a real example of what happened to duration in the span of one quarter: Q3 2016 to Q4 2016.
2.83 to 4.48 is a massive jump in duration from one quarter to the next. Keep in mind, this is only bad for the mREIT if there’s a significant change in rates. CYS, over one quarter, picked up 1.65 addition years of duration risk on its largest allocation. Overall, duration went up materially for the REIT’s portfolio.
Back to hedging
For a comparison in hedging strategies, I’ll be comparing CYS to AGNC. Remember for this comparison, CYS won the hedging battle when compared to other mREITs.
The hedging, on a percentile basis, looks similar – at least recently:
Q2 2017 and Q4 2016 are very similar between CYS and AGNC.
The hedging is not similar. CYS is hedging lightly compared to AGNC. This is because of duration on the hedges. Let’s take a look at the duration of hedging from AGNC:
The duration here is (3.9). Completely different compared to CYS:
The hedge duration for CYS is (2.57). Shorter-duration hedges were the answer to a flattening yield curve. Picking up these hedges is how the REIT is able to put its hedges in core EPS and still show it is able to cover the dividend. Other companies, such as NLY and AGNC, are hiding a portion of their hedging costs from core EPS.
CYS is going to have similar issues to other mortgage REITs down the road. For now, it looks fantastic. One of the reasons is because of the massive hike in rates. The hike caused less prepayments from homeowners. In turn, amortization costs dropped significantly:
Less amortization costs made the interest rate spread for CYS look quite attractive:
Less amortization and gains on hedging strategy have been two major metrics in creating the better interest rate spread.
Cost of funds is temporarily artificially low. As time goes on, hedging for CYS isn’t going to look as attractive. As time rolls on, the company will have to roll its hedges. Each quarter, some of the hedges expire. The new hedges to replace them will be at higher rates.
Further, CYS has a lot more duration risk after hedges. AGNC was carrying longer hedges. Consequently, AGNC was less exposed to changes in interest rate.
Interest rate sensitivity is materially higher for CYS than it is for AGNC. The chart below compares CYS and AGNC on a 50 bps change.
Taking an 8.91% hit instead of a 3.5% hit is massive. If rates start going up, CYS is going to get punched hard.
CYS is one of my favorite mortgage REITs. This has been for primarily two reasons: good management and clarity. I still believe the REIT has both, but the market seems to want less straightforwardness:
What does this mean?
First, let’s take a look at the consolidated statement of operations:
As an analyst, this is materially less useful than what CYS used to have here. On the plus side, the company still put the useful part in the presentation, just not on this slide (where it normally used to be in the past):
This helps an analyst have a much better view of what’s going on. The market norm stinks. The old CYS presentation was excellent. I’d like to see more clarity. I respect CYS for at least continuing to put this information in their presentations.
CYS Investments has made some stellar choices over the last few years. These choices have propelled it to cover a high dividend, while other mREITs are hiding their hedging expense.
For the time being, CYS shouldn’t have any issues covering dividends. In the long run, new hedging will hurt net interest income. The current environment of a flattening yield curve hurts the entire sector’s ability to sustain net interest income.
Net interest spread will suffer during later periods. For the next few quarters, CYS should have no problem covering its dividend.
Current outlook: Mildly bearish on CYS.
Long term issue, not short term. CYS’s dividend yield on book value is around 11.7%.
There is not a mortgage REIT that can sustain an 11.7% yield. The only reason CYS can cover its yield temporarily is due to a superior hedging strategy. As the hedges expire, CYS will be unable to sustain its current dividend rate on book.
Click The Mortgage REIT Forum to sign up for:
Actionable buy and sell target prices.
Best research on preferred shares and REITs.
Best reviews on the site – 244/245 stars.
Stable dividend yields over 7%.
You get instant actionable SMS alerts.
Sign up before October 1st, 2017, to lock in at $360/year.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.
Additional disclosure: No financial advice. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints. CWMF actively trades in preferred shares and may buy or sell anything in the sector without prior notice. Tipranks: Sell CYS.