Two Harbors Investment (TWO) was one of the mortgage REITs that we considered in our mREITs portfolio. Among the mREITs in the portfolio, Two Harbors continues to be the only REIT that positioned its assets portfolio in a way that enabled the company to earn the highest interest rate spread of 3.6%. Amid the non-existent interest rate environment, it offers an attractive dividend yield of 14%. The stock, when compared to its peers, is valued at a slight premium. The company's alternative investment strategy, and the blend of agency, non-agency, fixed-rate, and adjustable-rate mortgages make the stock an ideal diversified investment. These reasons, and the heavy insider buying witnessed during the current year, make us bullish on the stock.
Company Overview and Asset Portfolio Composition
Two Harbors Investment is one of the rarely followed mid-cap hybrid U.S. REITs, which aims to primarily invest in residential mortgage-backed securities for which principal and interest payments are guaranteed by any government-sponsored agency. It also seeks to invest in non-agency residential mortgage-backed securities and residential mortgage loans. As part of a diversification approach, the company also invests in single and multifamily residential real properties in the U.S. This is another reason why we have classified it as a hybrid REIT. The property is rented in order to generate income. Over the last five quarters, approximately 81% of the company's asset portfolio was composed up of agency MBS, most of which (approximately 82%) were fixed rate, while the remaining are adjustable rate mortgages (ARMs). The company's exposure to ARMs reduces its sensitivity toward interest rates and prepayments risk; however, the sensitivity from either is not totally eliminated. The company uses short-term investments, particularly repurchase agreements, which are float-rate debt instruments used to fund its assets portfolio.
Recent Quarter's Performance Review
The company earned a net interest spread of 3.6% during the second quarter of the current year, 30bps below what it earned during the first quarter. This was the lowest in the past four quarters. In comparison, both Annaly Capital (NLY) and American Capital (AGNC) posted a net interest spread of 1.54% and 1.65%, respectively. This is largely due to the fact that Two Harbors invests in high yielding non-agency securities, while Annaly Capital and American Capital exclusively invest in agency securities only. Like Annaly Capital and American Capital, the spread for Two Harbors declined largely due to the flattening of the yield curve. Due to the continuous efforts made by the Fed, the yield curve flattened, decreasing the yields on the assets that these mortgage REITs earned. An asset yield of 4.6%, which Two Harbors earned on its residential mortgage-backed securities, declined by 30bps compared to the linked quarter. This was lowest since the last year. At the same time, the company seemed to not have benefited from the declining short-term interest rates, as its cost of borrowing remained flat at 1% when compared to the previous quarter. This is still below the 1.5% and 1.08% costs of borrowing for Annaly Capital and American Capital , respectively.
Net interest income for the company during the second quarter surged to $90.4 million, up from $36.9 million during the prior year. Net interest income surged primarily due to a 161% surge in interest income coming from available-for-sale securities. Interest expense for the quarter surged to $15.5 million from $3.8 million in the first quarter.
U.S. housing is bottoming. This represents an attractive investment opportunity, and as an alternative investment, the company has been purchasing properties, including foreclosed homes, to be rented out. The company purchased homes worth $48 million in July, bringing total homes purchases since the beginning of the year to $120 million. Fitch is reluctant to give Two Harbors the best credit ratings owing to "limited performance data for the sector and individual property management firms." Analysts at Fitch further state that data on "market rents, rent roll histories, vacancy rates, and supply and demand" also have limited availability. If the rest of the credit rating agencies follow, the company might have difficulty raising debt in the future.
The following graph illustrates how heavy insider buying has been witnessed since the beginning of the year. A total of 115,500 shares were purchased by some of the top executives of the company, reflecting their bullish sentiments on the company's future.
Click to enlarge image.
Risks and Their Mitigation
Like all mREITs, Two Harbors' asset portfolio is subject to interest rate risk, prepayment risk, changes in home prices, and defaults by homeowners. However, the blend of agency and non-agency securities in the assets portfolio enables Two Harbors to reduce most of these risks. The company does not expect housing prices to stabilize fully during 2012. This, combined with the stubbornly high unemployment rate of 8.3%, lead the management to expect no significant acceleration in prepayments in 2012. However, we believe the Fed's continuous efforts to flatten the yield curve through Operation Twist, its maturity extension program, and the government-sponsored Home Affordable Refinance Program (HARP), have the potential to significantly affect the company's prepayment expectations.
The current economic situation validates the optimism over further easing by the Federal Reserve Bank. In the event of such easing, interest rates are expected to decrease further. In such a scenario, if interest rates decline by 50bps, Two Harbors, in its latest quarter filing to the SEC, mentions a 3.8% (or $14.9 million) decline in net interest income. At the same time, the value of total net assets will increase by $12.5 million.
As part of the company's investment strategy, the management deploys moderate debt in the capital structure, which is reflected in its leverage ratio of 4.8 times. This is in comparison to 3.4 times, 7.85 times and 8.66 times for MFA Financials (MFA), American Capital Agency, and Capstead Mortgage (CMO), respectively. The company maintains relations with 23 different counterparties for its funding requirements in order to reduce its counterparty risk. Besides having domestic counterparties, the company has relations with international counterparties in Europe and Asia. European counterparties constitute over 32% of the entire funding requirements of the company, while approximately 40% of the funding requirements are covered by international counterparties. Where this strategy reduces counterparty risk, it increases risk stemming from the European debt crisis. If the crisis worsens, Two Harbors could face a funding shortfall and might have to seek funding from other counterparties.
Dividends and Share-Repurchase Program
Mortgage REITs in the U.S. are well-known for their enormous shareholder distributions in terms of dividends, and TWO is no exception. In the prevailing nonexistent interest rate environment, Two Harbors' stock offers a massive dividend yield of 14% as compared to 1.71% offered by a 10-year U.S. treasury.
Besides, the company aims to distributed wealth among its shareholders through its share repurchase program. The management is authorized to repurchase 10 million shares of its common stock.
The stock, with a YTD performance of 24%, is trading close to its 52-week high and has a P/B value multiple of 1.15 times. The stock trades at a slight premium of 5.5%, 8.5%, and 8.5% when compared to Invesco Mortgage Capital (IVR), Capstead Mortgage and Annaly Capital, respectively.
Based on the above analysis, we recommend yield-hungry investors to buy the stock and reap the benefits of its sufficiently attractive dividend yield. The company employs moderate leverage giving it more room to increase debt to support its dividend distributions in the short term, and magnify results. This, however, should constitute a small part of the entire mREITs portfolio, and to better diversify the mREITs portfolio we recommend buying American Capital Agency and Annaly Capital.