We recently had a bullish public article on the common stock of Two Harbors (TWO). We are happy to reiterate that bullish rating today. Shares of TWO are materially undervalued and it is one of the larger positions in our portfolio today. We have a weighted average purchase price of $12.47 which is $0.10 higher than Friday's closing price.
Today, we will be taking a look at the preferred shares for TWO. Preferred shares are a great income tool for buy-and-hold investors along with traders. TWO’s preferred shares come with a risk rating of 2.5 making them a good fit for either.
How The REIT Forum looks at B&H positions
We tend to suggest sticking to securities that are below a risk rating of 4 when it comes to buy-and-hold investors.
Here's our reasoning:
We’re willing to hold risk rating 4 security on the expectation that the price will go up, but we want to monitor them carefully. We wouldn't be comfortable being tied to the position. If the risk rating is under 4, we are comfortable with being tied to at least a small position. We can't predict where prices will be 2 years from now on riskier securities, primarily because we can't be confident that management will be competent.
We would look to lower risk preferred shares if we were starting to build a new B&H portfolio. When it comes to risk ratings of 1 and 2, We can suggest buying those securities even if we knew the investor was going to log out of their account for the next two years. We give TWO’s preferred shares a risk rating of 2.5.
That's how we think about B&H positions. What would we be comfortable suggesting to an investor who is heading out on a two-year trip where they won't be able to access the account or respond to sell ratings? We would be comfortable suggesting shares with a risk rating of 1 or 2.
Some analysts think about risk differently. They can handle leading a defensive investor into a huge loss.
That's not us.
TWO preferred shares
Want a fixed-rate preferred share with a risk rating under 3 and a stripped yield over 7.8%?
Source: The REIT Forum
Take TWO-E (TWO.PE).
Shares have $0.33 in dividend accrual and trade at only $24.29. That’s $23.96 for the stripped price. If you’re looking for a little more yield on your fixed rate share, this one carries it. There isn’t any call protection on the calendar, but the investor would be taking a material capital gain.
We don’t expect a call any time soon though. TWO can’t refinance TWO-D (TWO.PD) or TWO-E at a low enough rate to make calling them worthwhile. They could call them just to remove preferred equity from their capital stack, but that’s unlikely. Recently, management of TWO indicated that they were happy with the amount of preferred equity in their capital structure.
Odds of a call are low and it would involve a material gain. That’s a nice deal. By contrast, it is much better than TWO-D. TWO-D carries the exact same stripped yield, also has no call protection, but trades at $25.08. You have to ask yourself:
“if shares were called in the future, would I want a big capital gain or not?” It’s an easy answer to pick TWO-E when the stripped yield is the same.
Ditch TWO-A (TWO.PA) at $26.90 with the proceeds going into TWO-E. While TWO-E’s stripped price fell by $.37 between 5/26/2019 and 6/2/2019, TWO-A’s stripped price INCREASED by $.25. What’s the difference? TWO-A has a great deal of call protection (out until 4/27/2027) before the floating rate of 5.66% over short-term rates kicks in. Remember that investors are currently a bit scared of fixed-to-floating shares.
TWO-A stripped yield of 7.63% vs. 7.83% on TWO-E. TWO-A trades at $26.90, TWO-E trades at $24.29.
We believe that investors looking to invest in TWO’s preferred shares would be best suited looking at TWO-E. We don’t expect a call anytime soon and management of TWO indicated that they were happy with the amount of preferred equity in their capital structure. We don’t want to establish a negative rating on TWO-A because we expect a moderate price decline offset by dividends. A total return of about 0% over 3-6 months doesn’t warrant a bearish rating, but investors should look to swap their shares of TWO-A for TWO-E.
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Disclosure: I am/we are long TWO. 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.