Two Harbors Investment Corp. (TWO) is a mortgage REIT. Its objective is to provide attractive risk-adjusted returns to its stockholders over the long term, primarily through dividends and secondarily through capital appreciation. It invests in Agency RMBS, Non-Agency RMBS, prime nonconforming residential mortgage loans, credit sensitive mortgage loans, and mortgage servicing rights. Other financial assets comprise about 5%-10% of its portfolio. It is externally managed and advised by PRCM Advisers LLC, a wholly-owned subsidiary of Pine River Capital Management LP. It currently pays a 12.27% dividend.
Q3 2012 was another volatile quarter; but this time the interest rates and the mortgage rates did not go straight up. They went up in the first two months of the quarter; and they fell approximately the same amount in the last month of the quarter. This was still a tough management quarter; and the results showed this. The book value fell from $10.47 per share to $10.35 per share (or -$0.12). When you add in the dividend declared of $0.28 per share for Q3 2013, investors profited by +$0.16 per share or 1.5% for Q3 2013 on a return on book value basis. Given the circumstances, this was a decent result. For the year, TWO's return on book value was +6.3%, which was far greater than the return on book value of its peers of -11.6% for the first nine months of 2013. The peers include: American Capital Agency Corp. (AGNC), ARMOUR Residential REIT Inc. (ARR), Anworth Mortgage Asset Corp. (ANH), Capstead Mortgage Corp. (CMO), CYS Investments Inc. (CYS), Hatteras Financial Corp. (HTS), Invesco Mortgage Capital Inc. (IVR), MFA Financial Inc. (MFA), and Annaly Capital Management Inc. (NLY). All of the peers listed above are respected mortgage REITs. This says a lot about TWO's 2013 performance relative to its peers.
Core earnings for Q3 2013 were $67.7 million or $0.19 per diluted weighted common share. TWO generated an aggregate yield of 4.0% in its RMBS portfolio. Partially the relatively low core earnings were due to the reduced leverage of 3.0x versus the Q2 2013 3.6x. Yields were driven by non-Agency performance of 9.0%. The net interest rate spread was 2.8%, which was an improvement over the 2.5% of Q2 2013. TWO completed the Agate Bay Mortgage Trust 2013-1, a $434 million securitization of residential mortgage loans. It repurchased 1.45 million of its shares at an average price of $9.23 per share, which was accretive to book value. It also completed a two-year flow sale agreement with PHH Mortgage Corp. to acquire MSRs (mortgage servicing rights) on newly originated residential mortgage loans. It is also in negotiations with other MSR sellers for additional investments near-term.
TWO had a net realized loss of $240.2 million, net of tax, due to the sale of $3.1B of RMBS with an amortized cost of $3.3B. It also had a variety of realized and unrealized gains and losses largely on derivatives, but in other areas as well. This led to a GAAP net loss of -$192.7 million (or -$0.53 per diluted weighted average common share) for Q3 2013. This was poor performance compared to GAAP net income of $388.6 million (or +$1.06 per common share) for Q2 2013. However, this just underscores the overall good performance relative to book value.
The table below describes TWO's portfolio breakout as of September 30, 2013.
The table below describes TWO's Agency holdings as of September 30, 2013.
As you can see above, 41.9% of the Agency portfolio is 30-year fixed rate Agency RMBS that are 4.0%-4.5% Agency RMBS. The chart below charts the recent value of the 30-year FNMA 4.0% MBS for the last year.
As you can see from the above chart, the 30-year FNMA 4.0% MBS has fallen approximately 1% in value thus far in Q4 2013. This could mean slight book value losses for TWO in its Agency portfolio in Q4. However, these should not be dramatic with the lower leverage level and the hedging. The non-Agency portfolio, the MSRs, etc. should still be profitable. At the present time, TWO should still do reasonably well in Q4 2013.
The chart of the 10-year US Treasury yield is below.
The above chart shows that interest rates have been rising again since late October 2013. The 10-year US Treasury yield may rise to test the 3.0% level again by the end of Q4 2013. Recent positive economic data may help this rise along. For instance, the Chinese PMI numbers for November 2013 of 51.4 for the government PMI and 50.8 for the HSBC PMI topped analysts' estimates. The numbers were both expansionary. Such data tends to make interest rates go up. The Chinese stimulus programs started in the summer of 2013 have been helping. However, it is unclear if these programs will have staying power with regard to economic stimulation. For instance, the private investment increase may peter out over time.
Longer term, BlackRock expects the US Treasury 10-year yield to finish 2014 in the 3.25% - 3.50% range. There is a lot that can change this outlook between now and then. It is by no means cast in stone either on the low side or on the high side. With this in mind, TWO looks like a less good investment; but it still looks good. It has hedges. The non-Agency portfolio gains tend to counteract the Agency losses. TWO may see another year of roughly a 10% composite book value/dividend gain. However, this is not bad in a perhaps very troubled market.
If everything falls apart in 2014, the Agency holdings should go up in value as interest rates fall again. This is the behavior a "flight to quality" would be expected to engender. If slow growth continues, TWO may see another year much like 2013. However, it seems unlikely that 2014 will see the same spike in 10-year US Treasury Note yields that we saw in Q2 2013. Rather the BlackRock prediction may come to pass. Almost any possibility in between is possible. It is also less probably, but still possible, that we will see a large rise in US Treasury 10-year note yields. Such an eventuality would hurt the entire US economy; and all stocks would likely fall. TWO would fall with them; but it should hold up better than most.
The two-year chart of TWO provides some technical direction for this trade.
The slow stochastic sub chart shows that TWO is near oversold levels. The main chart shows that TWO is likely bottoming in its recent downtrend. There is substantial technical support at the current price. Plus TWO is currently selling at approximately a 12% discount to its book value as of September 30, 2013. It could lose a bit more book value in Q4 2013, but that is likely to be on the order of the performance in Q3 2013. TWO is probably a weak buy. It would be a stronger buy, but there are too many unknowns in store for 2014.
The 12.27% dividend is probably in danger. The core earnings of $0.19 per common share were significantly lower than the $0.28 per common share dividend in Q3 2013. A dividend cut seems likely in the next couple of quarters, if not in Q4 2013. However, TWO should still have a good dividend. It is moving more capital into areas that are less susceptible to interest rate changes. It should do well long term. It has a four star CAPS rating (a buy).
NOTE: Some of the fundamental financial data above is from Yahoo Finance.
Good Luck Trading.