Hatteras Financial Corp. (NYSE:HTS) is an externally managed mortgage REIT that invests on a levered basis in mortgage backed securities and other related assets. Its principal and interest payments are guaranteed by government sponsored entities. I am neutral on the company because I see very few initiatives by the company's management to enhance its core EPS. The company is continuing with its defensive approach in a stable interest rate scenario. However, the company's dividends are well covered with its core EPS, including the special dollars.
There were no surprises for investors in the recent Fed meeting. The authority decided to continue a cut down in asset purchases to the tune of $10 billion, as anticipated by the market. Furthermore, the Fed also talked up the economy, as the labor market continued to improve, the economy expanded and inflation trends improved.
In the recent report on job data, it was disclosed that the economy added 209,000 jobs in July; the unemployment rate slightly increased by 0.1% to 6.2%. The two most important indicators, namely the labor force participation rate and growth in wages, have shown modest improvements in the month, which I believe is nowhere close to the Fed's liking. The labor force participation rate was up by 10bps and reached 62.9%. Average hourly earnings were up by only one cent. So, the slacks are definitely there, which will keep interest rates low.
Another important indicator used by the Fed is inflation, which remains well below its target in previous quarters. However, inflation is steadily moving towards the Fed's long term target of 2%. In the second quarter, the price index was up by 2.3%, which is the highest in the last three years.
The second quarter's GDP expanded by 4% annually, after the annual shrinkage of 2.9% in the first quarter. It was better than what economists had expected, who were predicting the growth rate to be at approximately 3%.
The strong growth was primarily driven by a 2.5% increase in consumer spending, as it is a major chunk of U.S. GDP. The savings rate was also moderately up, which paints an encouraging outlook for future spending. Inventories, business investments, and government spending also contributed to the expansion of the economy. Overall, the negative impact of the first quarter was neutralized by the improvement in the second quarter, and it is expected that the strong momentum will continue in the second half of the year.
I believe the slacks in the labor market will keep short term interest rates at their current levels. As indicated by Fed officials in a statement, "However, a range of labor market indicators suggest that there remains significant under utilization of labor resources." So, the FED will continue with its expansionary monetary policy. I believe mortgage REITs should pay close attention to the labor market and adjust their portfolios accordingly. Right now they should give up their defensive approaches and divert their investments to high yielding assets.
The company's core EPS of $0.63 was better than analyst expectations in the second quarter. The better performance was due to greater than anticipated dollar income, which more than off-set the lower net interest margin [NIM]. NIM declined due to the asset yield decreasing by 0.10% to 2.10%. The asset yield was pressurized by premium amortization and I am expecting this trend to continue, as CPR was also elevated in July. CPR was at 19.8% in July as compared to 17% in June. So, the premium amortization is expected to remain high for the third quarter.
There was no meaningful change in the company's portfolio. HTS invested 97% of its portfolio in adjustable rate MBS, whereas 3% is invested in fixed rate MBS. The company is heavily invested is adjustable rate and this is the reason why I believe the company will be able to perform better in a rising interest rate scenario. The portfolio will yield more as rates increase, hence improving its NIM and core EPS. However, currently interest rates are expected to remain low, which makes me neutral on the company.
The company is also exploring some encouraging investment options. First of all, HTS is looking to invest in seasoned adjustable rate MBS, which will lower its CPR. The seasoned investments are not refinanced as borrowers are left with lower net balances. Secondly, it is also looking to invest in the jumbo ARM market with its high yield. Both these initiatives will help support HTS' book value.
Dividends and Valuation
The company offers an attractive double digit sustainable dividend yield of 10.1%. The core EPS of $0.63 is sufficient to cover quarterly dividends of $0.50 per share. However, investors should not expect any increase in the dividend yield, as the management is keen to maintain its current yield. I expect the company to trade at a current discount of 10% to its book value. So, I am expecting no significant potential for price appreciation.
Due to the slack in the labor market, short term interest rates are expected to remain low in the near future. The economy has expanded by 4% in the second quarter, which gives confidence to investors. Overall, the economic environment looks favorable for mREITs with stable and predictable rates. However, I remain neutral on the company due to the absence of growth catalysts. However, the company continues to offers a safe double digit yield.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.