CYS Is Gambling On The Future; Do You Want To Gamble Too? – Seeking Alpha

Hopefully this article will help you grow your assets.

CYS Investments (NYSE:CYS) is an agency mortgage REIT. Its Q4 2016 book value losses were tremendous. CYS' book value as of September 31, 2016 was $9.79 per common share. As of December 31, 2016 the book value had fallen -$1.46 (or -14.9%) to $8.33 per common share. These losses were largely due to the large interest rate spurt higher in Q4 2016. The yield on the 10 year US Treasury Note rose from 1.59% on September 30, 2016 to 2.44% on December 31, 2016 (+85 bps). Widening basis spreads played a part too. That led to huge losses. It is hard to sustain such losses for very long. Hence it is appropriate to look at the likely future for CYS.

As of this writing on March 3, 2017, the fed funds futures indicate a 79.7% probability of a raise of +25 bps by the FOMC on March 15, 2017. At this point the market is also expecting 3 total fed funds rate raises in FY2017 (so two more after the probable March raise). Trump's first speech to Congress on February 28, 2017 seemed to energize interest rate rises again. His recent statements about huge spending on the US military have also energized fears of inflation. This in turn has caused the yield on the 10 year US Treasury Note to start to rise again (see chart below).

JPMorgan predicted on December 23, 2016 that the yield on the 10 year US Treasury Note might hit 3.5% in 2017. Of course, the above is an outlier prediction that is not necessarily expected to occur. Jeff Gundlach expects the yield to visit 3% in 2017, but he then expects it to revisit 2.25% before turning higher again. BMO is looking for a journey to 2.75% or higher in 2017. A trip above either 2.75% or perhaps 3.0% is expected to be very bad for stocks. In other words, many people will opt for safety at higher yields.

There are many other geopolitical events that could impact bond yields worldwide. The first of those is British PM Theresa May's promise to trigger Article 50 of the Lisbon Treaty by the end of March 2017. This will start the actual process of the UK leaving the EU. Her target date was March 15, 2017, but recent events may have pushed that date back to the end of March 2017. It is unclear what the exact effect of triggering Article 50 will be for the near term. However, the uncertainty associated with leaving the EU for Britain seems likely to push British and other sovereign bond yields upward. Don't forget that Scotland wants to remain in the EU. The Brexit could lead to Scotland leaving the UK. In other words, it could lead to more instability.

France is having a Presidential Election. The first round of this is April 23, 2017. Emmanuel Macron and Francois Fillon are the two leaders, but Marine Le Pen is expected to grab some of Fillon's followers after a recent scandal involving Fillon's wife. Marine Le Pen is thought to be in favor of France leaving the EU. This could lead to greater volatility both in EU equities markets and in EU bond markets. On March 15, 2017 the entire 150-member Parliament of the Netherlands will be elected. The outcome(s) of that election could determine if the Netherlands later opts for a Nexit (to leave the EU).

The latest round of Greek debt aid negotiations could impact French elections. The IMF is threatening to pull out as one of the funders of a further bailout, if Greek debt is not deemed sustainable by the Greek economy. In other words, if debt "relief" is deemed necessary to longer-term viability of Greek debt, then the IMF wants to see that happen. Other EU countries may have to pay a larger share on an IMF pull out, or they may have to recognize a loss on a write-down (haircut) agreement on Greek debt.

Later in the year on September 23, 2017, German federal elections are scheduled. Angela Merkel could lose power. A lot is up in the air. This is especially true of bond yields in the EU under these very unsettled circumstances. Bond yields in the US are certain to be affected by the EU situation. US bond yields are also subject to the whims and pronouncements of Donald Trump and the Congress.

CYS' portfolio as of Q4E 2016 is depicted in the rightmost chart and table below.

Readers should notice that the percentage of 30-year fixed rate RMBS rose dramatically from 42.9% at Q3E 2016 to 60.3% at Q4E 2016. The percentage of 15-year fixed RMBS fell by roughly the same percentage. This means that CYS' portfolio will be subject to more extension risk going forward. The shorter-duration RMBS usually have less extension risk. However, CYS has announced that they are trying to take advantage of the perhaps overly rapid rise in interest rates. If rates fall from here (or even later in 2017), CYS could profit nicely from the greater amount of investment in 30-year fixed rate RMBS. Depending on exactly when CYS made its changes, these could turn out to be very profitable new positions. If we instead see the 10 year US Treasury Note yield rise to 3.5% as some have indicated is possible in 2017, then this positioning could turn out to be very unprofitable for CYS.

The table below provides some more in-depth data about the same portfolio.

CYS also had some long (and some short) TBA positions as of December 31, 2016 compared to mostly short TBA positions as of September 31, 2016.

The charts below give a more graphic depiction of CYS' Q4E 2016 portfolio.

In the immediate past in Q4 2016, the GAAP Net Loss was -$185.4 million (or -$1.23 per diluted common share). Core Earnings plus Drop Income was $36.2 million ($28.1 million in Core Earnings and $8.1 million in Drop Income). Alternatively this was $0.24 per diluted common share. The Interest Rate Spread Net of Hedge, including Drop Income, was 1.28%. The leverage was 7.06x. Operating expenses were $5.2 million (or 1.26% of average stockholders' equity). Adjusting for a prior period tax charge, the operating expense ratio was 0.85%. The Constant Prepayment Rate was 14.2% for the quarter. CYS' duration was 1.02 as of December 31, 2016. This was up from 0.50 at September 30, 2016. The dividend declared December 12, 2016 was $0.25 per diluted common share. Core Earnings slightly failed to cover this.

CEO Kevin Grant does not believe in Trump's prediction of +4% US GDP growth. He points out that the labor force has been rising very slowly for the last 10 years (about +0.5%/year). The CBO currently projects the labor force as growing at about +0.4% for the next 10 years. The CBO is also estimating a pickup in labor productivity to +1.3%/year for the next 10 years. It has been rising at +0.9%/year for the last 10 years. Given the low labor force growth expectations and the low labor productivity growth expectations, CEO Grant does not expect to see continuous large rate rises that an expectation of +4.0% GDP Growth per year would engender. He is clearly betting on this. If you wish to bet along with him, then CYS may be a decent stock to be in. However, CYS' -$1.46 per diluted common share loss in Q4 2016 amounts to a total return in Q4 2016 of -12.36%, and that is after adding the $0.25 per diluted common share dividend back.

At this time the Trump "magic" has not completely disappeared. That likely means that the rises in yield rates for bonds have not completely disappeared. On top of that the overall market is over priced with a forward 12-month PE for the S&P500 of 17.9 and an average 5 year forward 12-month PE of 15.3. In other words the S&P500 would have to fall -14.5% just to get back to its 5 year average forward 12-month PE for the S&P 500. This means that CYS' share price is more likely to go down in the near term than to go up. The Beta of 0.76 means the stock price should roughly go up and down with the overall market. The share price at the close on March 3, 2017 was $7.84. This is only about -5.9% below the December 31, 2016 book value of $8.33 per diluted common share. CYS lost -14.9% of its book value in Q4 2016. CYS does not appear to be a good risk.

The two-year chart of CYS provides some technical direction for a trade/investment.

The chart above seems to indicate a consolidation phase after a short downtrend. It is unclear technically what is going to happen at this point. If CEO Kevin Grant proves correct, CYS could do moderately well in Q1 2017 and beyond. I have tried to present evidence (see far earlier in this article) that the yield on the 10 year US Treasury may go higher to 2.75% to 3.5% in 2017. Some pundits think a rise to 2.75% will be enough to trigger a large market sell off. Some pundits think such a sell off will only occur at 3.0% or higher. However, most seem to agree that higher yields on US Treasuries are likely to encourage a flight to safety. This is especially true when the dismantling of the EU may be in the offing in the next year or two. Certainly there is a lot of uncertainty about this. There is a lot of uncertainty about Italian banks, regardless of Italy's membership status in the EU. There is uncertainty about the finances of the Greek government. I could go on. I should have made my point by now. CYS is at best a HOLD at this time. I don't like to gamble on this type of stock.

NOTE: Some of the fundamental fiscal data above is from Yahoo Finance.

Good Luck Trading/Investing.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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CYS Is Gambling On The Future; Do You Want To Gamble Too? - Seeking Alpha