Two Harbors Investment Corp. (NYSE:TWO) is a hybrid mortgage REIT that invests in both agency and non-agency residential mortgage-backed securities, mortgage servicing rights, and other financial assets. I am bullish on the company because of its diversified portfolio, which is well positioned to hedge against rising rates through its swap positions and natural hedge in the shape of mortgage servicing. It also has a lower leverage amongst its peers, which means that the company can tap into attractive opportunities in the mortgage space. Furthermore, it continues to offer a compelling total return opportunity of 25%.
In the first quarter, the company reported core EPS of $0.24 which was $0.03 higher than the previous quarter. Improved performance was primarily attributed to 9.38% QoQ increase in the net interest spread. Asset yield was 30 bps higher than last quarter and the cost of funds was flat at 1.1%. I expect the solid momentum to continue because of the attractive opportunities available in non-agency MBS and MSR. Book value was up from $10.56 in the 4Q'13 to $10.71. It could have been higher by $0.02 if the core EPS covered the dividend payment completely.
Debt to equity ratio of 2.9x is also less than the peers average, increasing the borrowing capacity of the company and ensuring a strong balance sheet. William Roth, the Chief Investment Officer of the company, made clear in the last earnings call that if attractive opportunities arise at required ROE, then the ratio could go up. Therefore, I expect leverage to be high in the upcoming quarters which would help to increase the core EPS and dividend coverage.
The company has the flexibility to take advantage of non-agency mortgage REITs because they offer solid market risk premium. Net interest spread for non-agency RMBS is 6.7%, which is 4.4% higher than the net interest spread of agency RMBS. It does have credit risk, but economic fundamentals are improving. The U.S. economy added 288,000 jobs in the last month, bringing the unemployment rate down to 6.1%. The improvement in the job market is spread across almost all sectors. The market is also full of confidence and analysts are expecting GDP to grow at an annual rate of 4% in the second quarter, after shrinking by 2.9% in the first quarter. Capital allocation to credit is around 42%, which is expected to perform better in the improved economy with a lower credit risk.
MSR continues to be more attractive than traditional MBS. It acts as a natural hedge against the rising interest rate due to its negative duration. Although its yield is a high single digit, in a portfolio context it becomes more attractive as it helps to reduce the swap position. Additionally, it also provides hedge against the basis risk. TWO had added $121 million of flow unpaid principle balance from PHH Corporation (NYSE:PHH) and completed the purchase of a $5 billion bulk MSR after the end of the first quarter. The company continues to look for opportunities to expand its MSR portfolio through flow agreements, bulk sales and originators network.
With membership of the Federal Home Loan Bank [FHLB], TWO has also managed to diversify its funding source. The company has drawn $465 million at a rate of approximately 0.40% from its $1 billion line. This line gives the company access to long term borrowings at cheaper cost. The loan can be both fixed and floating. Moreover, the company is also less exposed to disruption in the repo market with an alternate source to raise money.
Low Prepayment Risk
TWO has a low constant prepayment rate (CPR) of 6.4% YTD, compared to peers average of 9.1%. More prepayments result in the shortening of the MBS life, which means lower yield. The company's current portfolio composition makes sure that the prepayments are kept in check. In the first quarter of 2014, the company increased its agency allocation of $85K max pools (less than $85000 in principal) and other low balance pools ($85000-$170,000 in principal). Refinancing of low balances MBS is not in the best interest of the borrowers after catering for the refinancing cost.
Similarly, high loan to value (greater than 80% LTV ratio) allocation was decreased which is beneficial for the company as HARP 2.0 (Home Affordable Refinance Program) has been extended till 2015. LTV ratio has to be greater than 80% for HARP program's eligibility; therefore TWO has done the right thing to decrease the allocation by 8% QoQ. Allocation to prepayment protected MBS and seasoned MBS was unchanged and remained at 5%.
The company is exposed to minimal interest rate risk. As shown in the figure below, TWO's portfolio is completely hedged against a 100bps increase or decrease in interest rates. In the first quarter, the company raised its notional principle to $9.5 billion as opposed to $5.1 billion in the previous quarter. I believe the company is over hedged and should reduce its swap positions to decrease its cost of funds and hence enhance its EPS.
Source: Company Report
I believe the stock should trade at a premium to its book value because of two reasons. Firstly, its non-agency RMBS credit risk has reduced because of improved economic conditions. Secondly, book value exposure to interest rates is minimal. Its average price-to-book value ratio for the past 5 years is 1.086x. So, my price target is $11.78 (1.086*BVPS). It means price appreciation of 14.6% and a total return of 25%.
There is a duration mismatch as the company funds its long term assets by the short term borrowing in the repo market. Although the company has accumulated longer duration funding from FHLB, it cannot completely replace the repo market. Hence the volatility in repo market could raise liquidity concerns consequently. The company is also exposed to unexpected movements in interest rates. It could deteriorate the book values, increase the hedging cost and reduce the net interest margins. TWO has a significant non agency exposure and its proceeds are not guaranteed by the government or its sponsored entities. So, TWO has credit risk which could also erode the book value. Lastly, low rates could cause the prepayments to speed up and the company will be forced to re-invest at lower rates.
I believe the company's significant exposure in non-agency RMBS and its MSR investments will help increase its earnings. The company also has access to a cheap source of funding through its membership with FHLB. With low sensitivity of interest rates to book value, TWO offers an excellent opportunity for those investors who were on the guard after the sector's poor performance last year.
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