With CYS Investments (NYSE: CYS ) reporting second quarter earnings later today, and Hatteras Financial (NYSE: HTS ) following on Wednesday, investors have their second chance this year to take an inside look at the two companies.
Unfortunately, with so many of today's companies insistent use of industry jargon and complex metrics, attempting to decipher what is actually going on becomes pretty darn complicated. That's why I broke down the three of the most import things to watch:
- Dividend stability
- Earnings potential
- Interest rate sensitivity
All of which can be determined simply, if you know where to look.
1. Is the dividend safe?
Skip past all the standard accounting metrics like net income and look for "core earnings per share." Because core earnings excludes one-time expenses and unrealized changes to derivatives and investments, it gives investors the most accurate glimpse into the company's "taxable income" – which is where the dividend comes from.
Ultimately, with CYS and Hatteras paying a $0.32 and $0.50 dividend, respectively, investors should makes sure that each companies' core earnings can cover the dividend -- hopefully, with some wiggle room.
2. What's the spread?
The interest rate spread is the difference between how much it costs CYS and Hatteras to fund their investments, and the yield on their assets. Since every company labels their data a little differently, for CYS it's called "interest rate spread net of hedge" and for Hatteras it's the "effective interest rate spread."
The larger the spread, the greater potential for profits. So, investors should want to see this metric getting larger, rather than narrowing. But, since spreads can widen or narrow for a number of reasons, it's most important to look for why the spread changed.
3. Are they prepared for rising interest rates?
Recent speeches from the president of the St. Louis Federal Reserve, James Bullard, and president of the Dallas Federal Reserve, Richard Fisher, seemed to indicate the economy is improving rapidly and interest rates may need to be increased sooner rather than later. Since mREITs are exposed to rising interest rates on both sides of their balance sheet, this is a big deal.
For CYS, investors will want to look at the "duration gap." This metric measures how well matched cash inflows are to cash outflows.
In short, the closer this number is to zero, the less rising or falling interest rates will impact the value of the company's assets. The chart below shows CYS' interest rate sensitivity in the first quarter.
If interest rate rise by 75 basis points (100 basis points equals one percentage point) CYS predicted the "fair value," or market value, of their assets would fall by 2% and stockholders' equity would get hammered.
In the first quarter, CYS was able to slightly reduce their duration gap by investing in U.S. Treasuries. Because these assets mature at predictable rate, it's easier to match these assets with funding. Also, when prepayment rates are low -- meaning the mortgage borrowers underlying CYS' securities are not refinancing or paying in excess of their regular monthly rate -- it make cash flows more predictable and easier to match with funding.
Best case scenario, prepayment rates stay low and CYS continues to restructure it's portfolio to lower it's duration gap.
Hatteras invests mainly in adjustable rate mortgages, or ARMs. Since the interest rate on these securities adjust with prevailing rates, Hatteras isn't quite as exposed as CYS – though, that doesn't mean the company is bulletproof.
The interest rate on ARMs start with a fixed rate and "reset" after a specified amount of time. This is why investors should look for the "months to reset." At the end of the first quarter, about two-thirds of the company's portfolio of ARMs will not adjust for three to seven years. I'll be curious to see if the company make any major changes to it's portfolio, perhaps added assets that will reset sooner.
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