Track the companies that matter to you. It's FREE! Click one of these fan favorites to get started: Apple; Google; Ford.



3 Things Investors Should Know Following CYS Investments' and Hatteras Financial's Earnings

Before CYS Investments  (NYSE: CYS  ) and Hatteras Financial  (NYSE: HTS  ) reported earnings I suggested investors be on the lookout for three things:

  1. Is the dividend safe?
  2. What's the potential for earnings?
  3. Are they prepared for rising interest rates?

With both companies' earnings in the books, it's time to dig in, answer these important questions, and determine just how confident investors should be moving forward.

Dividend stability
CYS and Hatteras payout their dividend using "taxable income." While few companies include this figure, most will highlight "core earnings" -- which is normally just as good. 

The key is making sure core earnings covers the dividend, hopefully, with a cushion to avoid decreases in earnings forcing dividend cuts. Here's what CYS and Hatteras' core earnings and dividends looks like over the past six-months: 

 Dividend and Core Earnings Through First Two Quarters - 2014
Company Q1 Core Earnings Q2 Core Earnings 6-months Core Earnings 6-months Dividends Payout Ratio
CYS Investments $0.35 $0.33 $0.68 $0.64 94%
Hatteras Financial $0.64 $0.63 $1.27 $1.00 79%

To qualify as a REIT, companies need to pay out 90% of their taxable income. So it might seem odd that six months into 2014 Hatteras' payout ratio (dividends divided by core earnings) is just 79%. Hatteras' CFO Ken Steele suggested that because there were "some losses from over-distributing based on earnings [last year] we can reduce the amount that has to be paid out this year."

As for CYS, 94% is right within the healthy range. If that number starts to creep into the high 90s or above 100%, however, that should throw up a red flag. For now, both companies' seem confident in their ability to maintain their current dividend. 

Earnings potential 
CYS and Hatteras earn the difference between what it costs to borrow (short-term rates) and the yield on their assets (long-term rates), or the "spread." When short-term interest rates are stable, as they have been, and longer-term rates fall, it narrows the gap and squeezes earnings.

As you can see in the chart above, spreads widened after the spike in bond yields in mid-2013, and spreads have trended downward since. For the time being, neither CYS or Hatteras' management seem concerned. If interest rates were to continue to decline for the remainder of 2014, however, this could become a much more significant problem.

Preparing for rising rates
Low volatility over the last few quarters has been a gift for mREITs. But according to CYS' CEO Kevin Grant, "While it seems and feels like we're in a period of stability, there are substantial crosscurrents over the horizon." CYS and Hatteras needed to take advantage this opportunity to improve portfolio durability, and I believe that's exactly what they did.

Perhaps the most complex of mREIT activities is matching the duration of cash inflows (assets) with cash outflows (borrowings) -- this is also referred to as the "duration gap." Because long-term bonds lose more market value when interest rates rise than short-term bonds, to lower the duration gap CYS and Hatteras needed to either lower the average maturity of assets, or increase the average maturity of funding.

During the second quarter CYS focused on lengthening the duration of borrowings, and Hatteras did a little bit of both.

The chart below shows CYS's predicted interest rate sensitivity in the first quarter compared to the second. As you can see, if interest rate rise by 75 basis points (100 basis points is equal to 1 percentage point) CYS takes a much smaller hit to their equity. Conversely, if interest rates continue to fall, they have a much smaller benefit.

Hatteras did not include interest rate sensitivity information in their earnings supplement, though, the company's sensitivity after the first quarter was very strong, and based on management's commentary -- which suggested they decreased some longer-term securities and lengthened funding -- I believe they're in an even better position today. 

Should investors be confident?
From a stability standpoint, I think investors should be very confident. Both company have an earnings cushion on their dividend, their investment approach is conservative, and their portfolios are well positioned to navigate rising interest rates. 

With that said, based on tighter spreads, the potential for bond market volatility to pick back up, and the necessity to be conservative due to the threat of rising rates, I expect returns to be underwhelming. For that reason, I would be holding rather than buying at this time.

Risk-free for 30 days: The Motley Fool's flagship service
Tom and David Gardner founded The Motley Fool over 20 years ago with the goal of helping the world invest...better. Their flagship service, Stock Advisor, has helped thousands of investors take control of their financial lives and beat the market. Click here to sign up today.

Read/Post Comments (0) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 3043966, ~/Articles/ArticleHandler.aspx, 9/5/2015 2:03:04 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Dave Koppenheffer

Dave Koppenheffer, is a contributor for the Motley Fool's financial sector. And much like Dwayne "The Rock" Johnson, when he speaks, he speaks with an earnest vibe and an earnest energy.

Today's Market

updated 4 hours ago Sponsored by:
DOW 16,102.38 -272.38 -1.66%
S&P 500 1,921.22 -29.91 -1.53%
NASD 4,683.92 -49.58 -1.05%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

9/4/2015 4:03 PM
CYS $7.63 Down -0.10 -1.29%
CYS Investments CAPS Rating: ****
HTS $15.96 Down -0.19 -1.18%
Hatteras Financial CAPS Rating: ****