High Dividend Hatteras Financial Corp. Will Benefit From Fed Policy And Q2 Investments

| About: Hatteras Financial (HTS)
This article is now exclusive for PRO subscribers.

Hatteras Financial Corp. (NYSE:HTS) is an externally managed mortgage REIT with a good dividend of 12.28%. It has a small to medium market cap of $2.87B. Notably $540 million of this came from a March 26, 2012 common equity offering. This turned out to be serendipitous as 10-year Treasuries hit their highest levels in about a year in late March 2012. This made net margin opportunities very attractive. This should help Q2 and later results. Much of the rest of the portfolio is also lower risk, higher return MBS. HTS owns agency backed MBS to lower its risk. These are both ARM and fixed rate MBS.

As of May 12, 2012 The yield on HTS' MBS was 2.20%. The cost of funds was 0.55%, and the net spread was 1.65%. The leverage was 7.5x. This is very healthy for this type of fund. With the leverage the total value of the portfolio was nearly $23B. The following chart shows how HTS has offset the risk of these securities via hedging.

As you can see, the amount of hedging increases with the time duration of the face of the MBS. The company prefers to operate on the short end of the yield curve because the risks are less. The biggest danger in this kind of investment is rapidly rising interest rates. The company is positioned for this. At the same time it is positioned for interest rates to go even lower. The ARM MBS are much less susceptible to prepayment rate increases because they reset (usually within one year) to reflect the changed interest rates. This means fewer home owners with these loans will feel the need to refinance at a lower rate. The chart below shows a few recent months' constant prepayment rates.

The CPRs have stayed in a relatively stable range. With the Fed trying to push interest rates down, it seems unlikely that they will go up dramatically soon. The old adage, "Don't fight the Fed.", is an appropriate encouragement for choosing HTS as an investment. The current loan rates are so low that it seems unlikely that even the Fed will be able to lower them much more. The 30 year fixed rate is 3.55%. The 15 year fixed rate is 2.89%. The 5/1 ARM refi rate is 2.71%. These rates should provide an approximate bottom for rates even with further Fed action. It should mean that HTS will be a "safe" investment for the next year or two. The Fed has already said it will try to keep Fed Funds rates low into 2014 if not into 2015. It will be watching the mortgage loan rates too. There is little doubt that the Fed will try to keep these low too.

Further the US housing market does seem to be finding a bottom at this time. This makes the value of the mortgages much more stable. HTS cuts risk further by selecting MBS based on homes in different geographical areas. HTS tries to select MBS for homes whose value is being supported by the replacement costs of the homes. For example, if it is more expensive to build a replacement home, then the value of the home has less downside potential. HTS' book value can also benefit from home price appreciation as the value of its MBS will go up with the price of the homes.

HTS' stock price has not moved up dramatically from the IPO price. However, its book value has increased from $22.20 at the end of Q1 in 2009 to $27.30 at the end of Q1 in 2012. That's an approximate 23% gain over 3 years. When you add this to the 12.28% dividend you get a nice return on your investment of approximately 19% per year.

The two year chart of HTS gives some technical direction to the trade.

The slow stochastic sub chart shows that HTS is near overbought levels. The main chart shows that HTS is in a weak uptrend. Given the fundamentals described above, HTS should be a buy. You may want to wait until it cycles below its 50-day SMA, or you may want to average in. The Q2 results are likely to be good. If that turns out to be the case, HTS may get a bit of a pop from those. The book value may go up a non-negligible amount too.

If you are interested in mortgage REITs, you might also wish to look at: CYS Investments Inc. (NYSE:CYS), American Capital Mortgage Investments (NASDAQ:MTGE), and American Capital Agency Corp. (NASDAQ:AGNC).

NOTE: Some of the fundamental financial data above was from Yahoo Finance.

Good Luck Trading.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in HTS over the next 72 hours.