Mortgage REIT Preferred Update: CYS Preferred Shares Look Attractive
08/04/2017 2:55 am EST
Among REIT preferred, CYS Investments is a current idea with no default risk in underlying mortgages, asserts Marvin Appel, MD, PhD. He’s president of Signalert Asset Management LLC.
I have long recommended holding mortgage REIT preferred because they pay more generous dividends than most other preferred issues and because the credit risks are easy to understand.
In particular, I have recommended AGNCB, AGNCP and NLY-E (formerly HTS-A). CYS Investments (CYS) has just released its second quarter results, and its preferred stocks also appear attractive as long term income holdings.
CYS uses shareholder equity and short-term borrowing to purchase mortgage-backed securities, most of which mature in 30 years. As with Annaly (NLY) and American Capital Agency (AGNC), CYS invests with leverage in federally guaranteed mortgage-backed securities. That means that there is no default risk in the underlying mortgages.
However, CYS uses leverage, currently 7.2:1, so any rise in long term interest rates that depresses the value of long term mortgages will have an outsized effect on the price of CYS shares, especially the common shares. As of June 30, the book value per share of CYS (common) was $8.31, roughly in line with the share price of $8.41.
The earnings from which CYS pays its dividends come from the spread between the lower short-term borrowing costs (average 1.37%) and the higher yield from the long term mortgages (2.86%). To the extent that short term borrowing costs rise faster than the yields on long term mortgages, interest income could be squeezed. Fortunately for preferred shareholders, that appears very unlikely because earnings far exceed preferred dividends.
Operating profits cover the preferred dividend with a large margin of safety
For the second quarter of 2017, CYS earned $50.9 million in net interest income. Subtracting from that amount the $5.4 million in quarterly operating expenses leaves $45.5 million available for dividends.
Preferred dividends (total for CYS-A and CYS-B) were $5.2 million, meaning that interest income less expenses were almost nine times the amount due to preferred shareholders. Common dividends for the second quarter were $37.9 million.
Mortgage REIT earnings consist of net interest income plus changes in the value of the portfolio of mortgage-backed securities plus profits or losses from hedging interest rate risk. To the extent that there are realized losses on mortgages and on hedges, that could cut into dividends. But the common dividend would have to be completely eliminated before preferred dividends can be suspended.
CYS-A and CYS-B are cumulative preferred stocks, which means that preferred shareholders must receive any missed dividends before any payment can resume to common shareholders.
CYS common pays 11.7% as a dividend yield. However, because of the greater volatility and dividend risk of the common, I recommend the preferred issues instead. CYS-A pays $1.9375 (7.75% of par) per year. It becomes callable on August 3, 2017.
CYS-B pays $1.875 (7.5% of par) per year. It is callable on April 30, 2018. I recommend either preferred issue if you can purchase it at $25 or lower. As of this writing, CYS-B is $24.80 and CYS-A is $25.09. Liquidity is sufficient for individuals to buy 500-1000 shares without moving the market, but not for us to purchase these stocks for our clients in any significant amount. (We have purchased other preferred stocks for appropriate client portfolios in addition to our other income-producing strategies.)
Mortgage REIT preferreds should be no more than 10% of your total investment portfolio in most cases.
Related Articles on STOCKS
Stefanie Kammerman, the Stock Whisperer, to tell you the Whisper of the Week: Facebook and ExxonMobi...
Join Ken Calhoun each week for a new episode of Breakout Chart of the Week for stock swing traders a...