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.

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