There are quite a few reasons to be bullish on CYS Investments (NYSE:CYS): Solid core earnings growth throughout 2013, an improved leverage ratio and a falling constant prepayment rate all suggest that CYS Investments' underlying performance metrics are improving.
Mortgage REITs are currently staging a strong comeback. While 2013 was a disaster year for the mortgage REIT sector due to a fundamentally changing interest rate environment and slower money supply growth, 2014 has actually been quite good for mortgage REITs so far.
CYS Investments is a specialty finance company that makes a business out of taking on leverage and investing funds in residential mortgage-backed securities. CYS Investments' core business consists of investing in agency residential mortgage-backed securities where principal and interest payments are guaranteed by government sponsored enterprises Fannie Mae and Freddie Mac as well as Ginnie Mae.
Improving sector sentiment
Mortgage REITs shot to prominence after the financial crisis led to record low interest rates and made leveraged business models very attractive. In addition, the preceding boom in the issuance of mortgage securities, and their subsequent collapse, offered investors high potential risk-adjusted returns.
CYS Investments took full advantage of the opportune environment; delivering solid returns to shareholders from 2010-2012.
Not surprisingly, as the tide started to turn in 2013, mortgage REITs including CYS Investments increasingly came under pressure. As a result, CYS Investments had to adjust its dividend payouts.
Dividends have been substantially reduced and should be sustainable from here on
While CYS Investments did always pay investors handsomely, the dividend adjustment process has hurt shareholders.
In the third quarter of 2010, CYS Investments paid investors a quarterly cash dividend of $0.60 per share leading to high double-digit dividend yields.
Increasing interest rate volatility in 2013 put a lot pressure on CYS Investments mortgage portfolio and profitability (as well as on other mortgage REITs) and dividend payouts have been adjusted accordingly: CYS Investments now pays investors $0.32 per share, about half of what it paid investors during peak times.
However, at a current share price of around $9 per share, CYS Investments still yields a fantastic 14% and even outperforms the solid 10% yields that industry giants Annaly Capital Management (NYSE:NLY) and American Capital Agency Corporation (NASDAQ:AGNC) offer.
Improving portfolio metrics and solid core earnings
One of the key challenges for CYS Investments is to manage prepayment risk. Prepayment risk results from changes in interest rates and falling interest rates oftentimes lead to a flood of mortgage refinancings. Prepayments result in the early receipt of principal which then has to be reinvested at a lower prevailing market rate.
As such, it clearly is a good thing for CYS Investments that its constant prepayment rate has fallen to 5.6% in the most recent quarter. Just one year ago the constant prepayment rate stood at a whopping 17.5%.
While CYS Investments' GAAP net income has been quite volatile, the metric bears little significance for mortgage REITs. It is much better to look at CYS Investments' core earnings as a reflection of its true earnings power.
In fact, CYS Investments' core income has risen from $0.17 per common share in the first quarter of 2013 to $0.28 per common share in the most recent quarter. The growth trend is quite encouraging and signals that the worst is over for CYS Investments and the mortgage REIT sector.
In addition to improving portfolio metrics, CYS Investments has reacted to increasing uncertainty and consistently lowered its leverage ratio in 2013.
In the first quarter of 2013, CYS Investments' leverage ratio stood at 7.8 times while the REIT has brought its leverage ratio down to 6.3 times just one year later. De-risking its balance sheet has been a strategic move demanded by investors and CYS Investments certainly has delivered.
Growing core earnings, an improving leverage ratio, significantly lower prepayment rates and a 14% dividend yield suggest, that CYS Investment certainly is on the right path to create value for shareholders.
With improving investor sentiment and a strong performance of mortgage REITs so far in 2013, it might be just the right time to buy.
Kingkarn Amjaroen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.