Two Harbors Investment Corporation (TWO) is a hybrid mortgage REIT company, which primary deals between residential mortgage-backed securities and other related investments. I reiterate my bullish stance on the company, as it has a well diversified portfolio. The expansion of its mortgage servicing rights (MSR) portfolio paints an encouraging outlook in the rising interest rate scenario. It would also help narrow down the difference between its price and book value. So, with a solid dividend yield of 10.90%, the company offers a compelling total return opportunity.
Mortgage Servicing Rights [MSR]
Since the announcement of tapering earlier this year, TWO has adopted a defensive strategy by lowering its leverage, reducing agency exposure and increasing swaps hedging just like its peer companies. But I believe the company has a bright future going forward because of its license to invest in MSR, as they are more attractive than traditional MBS. In the third quarter, company's swap and swaption notional principle stands at $22 billion, which I believe can be significantly reduced because MSR could act as a natural hedge against the rising interest rate due to its negative duration. So, I think the company is over-hedged and they should cut down on its swap, which would not only save its cost, but improve the bottom line of the company. The company also carries $440 million worth of credit sensitive loans (CSL), which is also expected to perform well in a strong growing economy where credit risk is low.
The management has been maintaining low leverage and excess capital to further enhance its MSR portfolio. Recently, the company announced that it will acquire a pool of MSR rights from Flagstar for 500 million through Matrix Financial Service Corp. The portfolio consists of Ginnie Mae and Fannie Mae loans with $40.7 billion in an unpaid principal. Also, the company has bought servicing rights for around 50% or more newly originated PHHs residential mortgage loans.
MSR should offset the poor performance of agency MBS in the rising interest rate scenario. So, I believe that the company should trade at a premium to its book value, as it has done in the past. My price target is $10.35 based on 1Xbvps, which equals price appreciation of 11.65%. It has also repurchased 1.45 million shares for a total cost of $13.4 million with an average price $9.24 per share, which means that the management strongly believes that its shares are undervalued. Furthermore, TWO offers a decent dividend yield of 10.90%, which promises a strong total return.
Earlier this month, the Fed announced that it would start to cut down on its asset purchases by trimming $5 billion each from its mortgage and treasury bonds purchases. As discussed in my previous article, "Mixed Bag for Investors When It Comes to Annaly Capital", the tapering will not be such a concern if economic indicators are strong and the market is growing as indicated by lower unemployment rates, growing retail sales and the housing market. It is also important to note that the change is not a big one, as Bernanke said it might take a year to fully cut down $85 billion in asset purchases given that the job and inflation targets are met. Furthermore, he also reaffirmed that they have no intension to change overall short term interest rates in the near future and that they are expected to remain low even longer than had been previously expected. Another encouraging sign is that new Fed Chairman Janet Yellen completely agrees with the policy and it is expected to continue in the future as well. So, I believe there is no reason for investors to remain on the guard for mortgage REITs because of tapering, as deteriorating book values and dividend cuts will stabilize in 2014.
The company carries two major types of risks, which are interest risk and credit risk. Its portfolio is heavily invested in 30-year fixed MBS, which means the rises in interest rates will result in a decline in the company's book value. Also, it will result in an increase in borrowing cost. Secondly, the company has significant positions in non-agency MBS and CSL, so credit deterioration is a significant risk for TWO.
The company has been trading at the bottom end of its 52-week range of $8.94-$13.05, and with the tightening price-to-book value gap, we can expect a price appreciation. My top pick among mortgage REIT companies is definitely TWO because of its MSR, which tend to perform well in rising interest rate scenario. Moreover, the gradual cut down of $85 billion in Fed buying will not remain such a big concern if the economy continues to show improvements.