Investment Portfolio
The company’s Agency residential mortgage backed securities at the end of the first quarter of the current year totaled $20.2 billion, down 5% from the prior quarter. Its composition was more tilted towards MBS forwards with 23.2% invested in forwards (Forward MBS isderivedfrom the fact that actual mortgage backed securities that will be delivered to fulfill a To Be Announced (TBA) trade is not designated at the time of the trade). Given the prevailing QE3 and the resultant attractiveness of MBS forwards, you can expect CYS Investments Inc (NYSE:CYS) to maintain a larger weighting to forwards for the remainder of the current year.
Financials
The company reported interest income of $73.1 million compared to 79.6 million at the end of the linked quarter. This can be attributed to declines in the investment portfolio and the net interest rate spread. Interest expense of $37 million increased 4% over the prior quarter as a result of a hike in cost of funds. As a result, the company posted $36.1 million in net interest income, down 18% sequentially.
Interest Rate Spread
Since CYS Investments invests exclusively in Agency mortgage backed securities, you can expect it to report a decline in its key matrix, the net interest rate spread. During the quarter, the company reported a 19 bps sequential decline in its spread of 0.75%. Much of the decline in the spread was a result of the 17 bps plunge in asset yields, while the 2 bps hike in the cost of funds covered the rest.
Including the forward MBS, CYS Investments Inc (NYSE:CYS) reported a 1.16% net interest spread, down 15 bps from the linked quarter. As some of the forward MBS settle in the coming quarters, you can expect the company to report a higher spread.
However, the spreads are much more dependent on the Fed’s activities. If QE3 continues or is increased, you should expect the spreads at CYS Investments to contract further. Therefore, you should keep a close eye on the Fed’s moves.
Hedges and Leverage
The company has started hedging more during the quarter. The percentage of repurchase agreements swapped increased from 54% during the prior quarter to 65% during the most recent quarter. Further, the company increased its hedge with additional interest rate cap coverage to 30% from the prior quarter’s 24%.
The company increased its debt levels by 0.2x during the fourth quarter. At the end of the first quarter of the current year, CYS Investments reported a leverage of 7.9x.
Undervalued
The company reported book value per share of $12.87 compared to $13.31 per share at the end of the fourth quarter of 2012. This is a sequential decrease of 3%. Since each share of CYS Investments Inc (NYSE:CYS) is currently exchanging hands aroudn $11.88, the stock is trading at an 8% discount to its book value. Therefore, the stock is undervalued and attractive compared to its book value.
Competition
CYS Investments is competing with American Capital Agency Corp. (NASDAQ:AGNC), Annaly Capital Management and ARMOUR Residential REIT, Inc. (NYSE:ARR) to purchase Agency residential mortgage backed securities. According to Yahoo Finance, American Capital Agency Corp. (NASDAQ:AGNC) and Annaly Capital Management, Inc. (NYSE:NLY) are scheduled to report their first quarter performances on April 29. Analysts expect $0.34 and $0.23 in income per share from Annaly Capital Management, Inc. (NYSE:NLY) and ARMOUR Residential REIT, Inc. (NYSE:ARR), respectively. For American Capital Agency, the estimated EPS is $4.28 per share.
Conclusion
Given the continuation of QE3, you should expect declines in the net interest rate spread of Agency mREITs. However, for CYS Investments Inc (NYSE:CYS) the situation could be favorable due to its forward MBS. Therefore, you should buy CYS Investments and benefit from the expected expansion in its spread.
The article This Agency mREIT Could Expand its Spread originally appeared on Fool.com and is written by Adnan Khan.
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