12.57% Dividend Payer Two Harbors Investment Corp. Is A Buy Even With Falling Mortgage Rates

 |  About: Two Harbors Investment Corp. (TWO), Includes: AGNC, NLY, NYMT, RSO, RWT
by: David White

Two Harbors Investment Corp. (NYSE:TWO) is a hybrid mortgage REIT. Unlike some mortgage REITS such as American Capital Agency Corp. (NASDAQ:AGNC) and Annaly Capital Management Inc. (NYSE:NLY), which invest almost solely in agency mortgage backed securities, TWO invests in both agency and non-agency RMBS, residential mortgage loans, residential real properties, and other financial assets. TWO has a total RMBS portfolio of $15B+ and a market capitalization of $3.4B. For this portfolio approximately 82% are Agency RMBS and about 18% are non-Agency MBS. TWO has had a total stockholder return of 95% since October 2009. It had paid a recent dividend per quarter of $0.40 per share. It recently announced that it had lowered the dividend for Q3 2012 to $0.36 per share (12.57% if annualized). This was largely due to the current and expected decrease in interest rate spreads between the cost of money and the rates earned on the agency RMBS. The latest decrease in interest rates spreads expected is due to the Fed's new QE3 program of buying MBS. With the MBS it was already buying the Fed is now buying about $70B in MBS per month. TWO has also announced that its book value per share has moved up from $9.94 at the end of Q2 2012 to "hybrid mortgage REIT" at the end of Q3 2012. This is by far the highest book value per share the company has achieved. It means TWO is that much greater a value play at its current price of $11.46 per share.

Partially in response to the falling interest rate spread (also due to the good opportunities available), TWO has been acquiring single family rental properties. TWO plans to contribute its single family assets to Silver Bay Realty Trust in exchange for shares in the company, which will also be an REIT. Silver Bay Realty Trust in mid-September filed for an IPO. It will be externally managed by Pine River Capital Management and Provident Real Estate Advisors LLC, a private capital management firm. This is the same firm that externally manages TWO. Silver Bay intends to use the proceeds from the IPO to purchase additional single family properties. Given the number of distressed homes currently on the market this seems an excellent strategy. It is even more appealing when you realize that Pine River Capital Management and Provident Real Estate Advisors LLC and TWO may be able to easily dispose of foreclosed on properties quickly for a decent profit using this venue. TWO may also be able to make a quick profit on single family homes it is able to pick up at huge discounts in the normal course of business. Silver Bay in its turn will be able to acquire properties easily at big discounts to fair market value. This looks like a WIN-WIN arrangement.

The chart below shows TWO's most recent quarters' annualized yields of RMBS types in its portfolio.

The decline in average portfolio yield from 5.4% in Q2 2011 to 4.6% in Q2 2012 does not seem to be bad management. It is instead likely due to a narrowing of spreads recently. Unfortunately this seems likely to continue in Q3 2012 as the 30 year fixed mortgage rate has gone down about 0.20% since the Fed announced its new MBS buying program -- QE3. The 30 year fixed is at 3.30% as of early Tuesday October 16, 2012. The good news is that this is partly responsible for increases in TWO's book value of $1+ during Q3 2012. Further with the increased help from the Fed, the already bottoming housing market has started to rise slowly. This should lead to further increases in book value, especially among the non-Agency loans. TWO deliberately tries to focus on deeply discounted non-Agency MBS, so it can take full advantage of such market value improvements. Further there has been steadily improving underlying loan performance since the recession. Since the leverage in the non-Agency RMBS is only 1.0x to 1.5x, the risk is not unreasonable. Companies such as NLY and AGNC will see much less of this. They invest almost exclusively in Agency loans. This should make TWO a more attractive investment under the current conditions.

The move to investing directly in real estate seems likely to be helped by the decrease in mortgage rates too. Making homes more affordable should act to drive demand for homes up along with home prices. This should engender greater gains via direct investment, even if the direct investment will now be more convoluted via the Silver Bay Realty Trust. TWO has also acted to improve management. It has lowered its expense ratio year over year in Q2 2012 from 1.1% to 0.8%.

Constant Prepayment Rates are the enemy of good performance in this sector. TWO's CPRs are very competitive. Many other mortgage REITs operate with CPRs in the low to high teens. The hybrid mortgage REIT shows TWO's recent performance versus government entities. TWO's performance is far better.

The chart below shows TWO's non-Agency portfolio breakout as of the end of Q2 2012. TWO has increased its percentage of Sub-Prime loans dramatically over the last two years as these loans have stabilized (from 26% in Q1 2012 to 84% at the end of Q2 2012). It helps to have the Fed backing your play. When you buy at huge discounts in this area, it is hard to lose in a housing market recovery. As you can see in the following chart of Case Shiller LA and SF hybrid mortgage REIT, the outlook in housing is looking up.

(click to enlarge)Click to enlarge

Further during the post recession time, the 60+ day delinquencies have decrease from 46% in October of 2009 to 34% in June of 2012. The percentage of underwater loans has also decreased. Plus the market price of an example sub-prime senior bond has increased from $62.4 on April 15, 2011 to $75.5 approximately at the end of Q3 2012. With such greatly improving fundamentals (and the consistent low rates the Fed is virtually guaranteeing through mid-2015), TWO looks like a great investment, even given the dividend cut to 12.57% for Q3 2012. Plus TWO does do considerable hedging to ensure against loss of book value if interest rates rise. It uses a variety of tools such as swaps, swaptions, and interest-only bonds. TWO looks like a buy to me. I like the dividend (12.57%), the book value of $11+ per share versus the stock price of $11.46 per share, the improving fundamentals in the housing market, and the fact that the Fed is clearly backing the housing market. If this changes, I might change my mind about the investment. For now, TWO is a solid buy.

The two year chart of TWO provides some technical direction for the trade.

(click to enlarge)Click to enlarge

The slow stochastic sub chart shows that TWO is neither overbought nor oversold. The main chart shows that TWO is in a strong uptrend, but it has recently retraced. Since there are fundamental reasons (the narrowing of the Agency RMBS credit spreads especially), you may wish to consider that TWO could continue to go lower. However, I do think it is a still solid buy. Therefore averaging in is appropriate. You may wish to consider the fiscal cliff as you do this. Anything that may take the entire equities market (and possibly the real estate market) down may impact the price of TWO in the short term. Averaging in around the fiscal cliff is probably a good idea too. TWO trades at a PE of 10.62, which seems quite reasonable.

If you are interested in mortgage REITs that invest in substantial amount of instruments other than Agency RMBS, you might consider Resource Capital Corp. (NYSE:RSO), which invests in CMBS, mezzanine loans, etc., and New York Mortgage Trust Inc. (NASDAQ:NYMT), which also invests in CMBS as well as RMBS. You might also look at Redwood Trust Inc. (NYSE:RWT), which carries both residential and commercial loans , etc. The above have substantial assets which will not be as vulnerable to interest rate lowering due to Fed actions.

Note: Some of the above fundamental data is from Yahoo Finance.

Good Luck Trading.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in TWO over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.