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Hatteras Financial Corp (NYSE:HTS), like other mortgage REITs, has been favored by the Fed for quite some time now. The sluggish U.S. economy now demands yet another round of quantitative easing by the Federal Reserve. If the said round of easing is carried out, HTS will be one of the major beneficiaries, as its already-low cost of funds will become even lower. Besides, due the vast majority of adjustable rate securities, the company has structured its assets portfolio in such a way that a decrease in interest rates will enhance the company's net interest income, thus brightening the chances of a dividend hike. The stock offers an attractive and sustainable dividend yield of 12.4%, and is trading at a cheap book value multiple. A large adjustable rate securities portfolio decreases the company's prepayment and interest rate risk. These are the reasons why we recommend our investors buy the stock.

Business Overview

Hatteras Financial Corp is organized to operate as a mortgage REIT in the U.S. financial sector. The company seeks to invest exclusively in single-family residential mortgage pass-through securities, for which the principal and interest payments are guaranteed by a government-sponsored agency (agency security). In order to generate elevated returns for shareholders through dividends, the company funds its agency securities through short-term borrowings (repurchase agreements). The company then earns the difference between the interest it earned on its interest yielding assets and the interest it pays on its interest bearing liabilities.

Securities Portfolio Composition and Borrowings

To minimize the risk of prepayments and interest rate risk, the company aims to invest in assets with predictable prepayment characteristics and shorter durations. Besides investing in fixed rate agency securities, the company also invests in hybrid and adjustable rate mortgages that have floating interest rates that reset after a specific interval. The company had $22.4 billion at the end of the second quarter in its assets portfolio, of which approximately 93% are adjustable rate securities, while the remaining constitutes fixed rate agency securities. The surge in assets at the end of the recently ended second quarter, over the December 31, 2011, balance of $17.74 billion, is 26%. The larger proportion of adjustable rate securities has the tendency to reduce both interest rate risk and prepayment risk for the company.

To fund its assets portfolio, the company borrows short-term using repurchase agreements. These repurchase agreements, which stood at $20.2 billion at the end of the second quarter of the current year, have a weighted average maturity of 24 days. Borrowings at the end of the second quarter of the current year surged 25% over the December 31, 2011, balance of $16.16 billion. To diversify its counterparty risk, the company maintains relations with 30 counterparties and has outstanding borrowings with 23 counterparties.

Recent Quarter's Business Performance

Interest income of $129 million, which the company generated during the first quarter of the current year, surged 13.7% over the previous year. The surge was primarily associated with the aforementioned increase in the interest yielding asset base, partially offset by the record-low interest rate environment and the flattening of the yield curve; these developments come as a result of several initiatives by the Federal Reserve that decreased the yield on average assets. Asset yields earned during the second quarter of the current year decreased a significant 60bps to reach 2.43% over the past one year.

Interest expense of $46.2 million, which is basically the interest that the company paid on its interest yielding liabilities, surged 29% over the previous year. The surge was primarily associated with the aforementioned increase in the company's borrowings, partially offset by the non-existent interest rate environment. The company seems to have benefited from the non-existent interest rate environment, as its cost of funds decreased 12bps over the past year to reach 0.94%.

The 1.49% net interest spread that the company earned during the second quarter of the current year produced net interest income of $83 million. The net interest income surged 7% over the previous year. The net interest spread decreased 48bps over the previous year. The surge in net interest income was largely associated with the increase in interest income, partially offset by the increase in interest expense.

Total operating expenses and gains on sale of mortgage-backed securities surged 35% and 177%, respectively. The company generated a bottom line of $89 million at the end of the second quarter of the current year, as opposed to $77.5 million in the same quarter last year.

Leverage

Most mREITs are highly leveraged in order to magnify their results. At the end of the second quarter of the current year, the company's leverage ratio stood at 7.5 times. This is comparable to American Capital Agency (NASDAQ:AGNC)'s leverage ratio of 7.8 times. Armour Residential (NYSE:ARR) has a leverage ratio of 8.9 times, while Capstead Mortgage (NYSE:CMO) has a leverage ratio of 8.6 times. This reflects that Hatteras Financial has room to increase debt in its capital structure and further magnify its results.

Dividends

Like other mREITs in the U.S. financial sector, HTS offers a generous dividend yield to its shareholders. The stock offers a dividend yield of 12.42% against the prevailing 10-year treasury rate of 1.66%. The trailing 12 month operating cash flow yield for the stock is 14%. The company paid $140 million in dividends in the most recent quarter, and generated operating cash flows of $199 million. The dividend distribution is fairly sustainable, and investors can expect dividends to continue in the foreseeable future.

Valuations

Trading at a premium of 6% to its book value, HTS is cheaply valued when compared to most of its peers in the U.S. mREITs industry. American Capital Agency , which invests exclusively in agency-backed mortgages like HTS, and has a similar leverage ratio, trades at a premium of 18%. Two Harbors (NYSE:TWO) is trading at a 17% premium to its book value.

Outlook

There are wide expectations that the Fed will initiate fresh efforts to stimulate the sluggish U.S. economy. In this event, the already non-existent interest rates are expected to decrease further. According to the company's quarterly filings, Hatteras Financial's projected net interest income will increase by approximately 3% in case the country experiences an instantaneous parallel shift of 50bps in the yield curve. However, we believe any initiative by the Fed will not bring about such a parallel shift in the yield curve. Short-term interest rates are already at their lowest, yielding 25bps.

In case the interest rates are allowed to surge, a 50bps instantaneous parallel shift in the yield curve will result in a 2.25% decrease in the company's projected net interest income.

Source: 12.4% Dividend Yield, Cheap Valuations Make Hatteras Financial A Must Buy Dividend Stock