American Capital Agency Corp. (AGNC), CYS Investments Inc (CYS): What Does the Dividend Hike For This Agency mREIT Mean?

CYS Investments Inc (NYSE:CYShiked its quarterly dividend in  the second quarter of the current year. Given the challenging macroeconomic situation that mREITs are currently facing, the correct interpretation of the hike in CYS Investments dividends is important. Let’s see where did the hike come from and what is does it mean for other Agency mREITs.

CYS Investments Inc

The company

CYS Investments has a fairly simple policy of investing in residential mortgage backed securities that have the government’s backing (Agency MBS). This qualifies the company to be a pure-play mREIT. The company’s Agency MBS’ are both fixed rate and adjustable rate in nature.

The dividend hike

Given the speculation about the Fed’s exit, mortgage rates have climbed, causing erosion in the book values of most mREITs. Analysts are expecting sector-wide dividend cuts. However, Credit Suisse expected CYS Investments to continue its first quarter’s dividend rate of $0.32 per share. In contrast, CYS Investments Inc (NYSE:CYS) reported a 6.25% sequential increase in the quarterly dividend rate, to $0.34 per share. The recent dividend hike is also in sharp contrast to the dividend cuts during prior quarters.

Where did the hike come from?

Since Ben Bernanke’s recent speech, Agency residential mREITs have been under tremendous pressure. Mortgage rates started climbing, causing mREITs to estimate huge book value depreciations. In particular, CYS Investments was not prepared for the hike in rates, and had constructed its portfolio to create benefit for the company if the rates dropped further. In the case of a 25 bps increase in the rates, CYS Investments anticipates a 10.3% decline in the coming quarter’s net income.

So, rates are on the rise, and CYS Investments Inc (NYSE:CYS) expects a decline in its bottom line: Where did the hike come from? The answer: realized gains from the past.

The company realized $500 million in gains over the past two years. Even during the first quarter, CYS investments generated $55 million from gains on investments, compared to $30 million from interest income. Around $0.16 per share was withheld by the company during the first quarter, which is now being distributed and is the source of the dividend rate increase. However, further hikes are highly unlikely as gains on investments have dried up due to higher mortgage rates.

Significance of the hike

Since CYS Investments Inc (NYSE:CYS) is a pure-play mREIT, I will attempt to compare it with other pure-play mREITs like American Capital Agency Corp. (NASDAQ:AGNC), Annaly Capital Management, Inc. (NYSE:NLYand ARMOUR Residential REIT, Inc. (NYSE:ARR). It is evident that CYS Investments dividend hike was due to past undistributed income. Therefore, investors should not expect American Capital to follow.

A dividend cut is expected when American Capital Agency reports its second quarter dividends. Credit Suisse expects American Capital to slash its dividends by 20% to $1 per share. This is largely because it too was not ready for Fed’s exit. It had constructed a portfolio to benefit from lower interest rates. The company anticipates a decline in its net interest income if the rates continue their upwards journey.

ARMOUR Residential has just recently declared its third quarter monthly dividend rate of $0.07, or $0.21 per share on a quarterly basis. This is down from the prior quarter’s dividend payment of $0.24 per share. ARMOUR made purchases of new production MBS after it raised equity, thinking the Fed will continue its easing. However, the Fed signaled otherwise and the rates started climbing, causing ARMOUR’s stock price to decline, because its net interest income is anticipated to decline.

The case of Annaly Capital Management is different from the rest of the mREITs. It is the largest and one of the best managed mREITs. It has less leverage (6.7 times, compared to 9 times for ARMOUR) in its capital structure which reduces volatility in its net interest income. Further, the presence of commercial real estate loans and the returns coming from CreXus Investments provide a cushion to the company’s book value and net income, respectively. The cost savings of up to 13 bps due to the externalization of the management cannot be ignored. Therefore, with the solid support to the bottom line, I expect the company to maintain its $0.40 per share.

Foolish takeaway

Much of the dividend hike in CYS Investments Inc (NYSE:CYS) can be associated to prior quarter’s undistributed income. Therefore, the hike cannot be termed sustainable and investors should not expect other pure-play mREITs like American Capital Agency to follow. However, Annaly Capital has a better chance to maintain its dividends due to the aforementioned company specific positive drivers.

Adnan Khan has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.

The article What Does the Dividend Hike For This Agency mREIT Mean? originally appeared on Fool.com.

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