Four Reasons to Buy This 18% Dividend Yielder
Adnan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Two Harbors Investment (NYSE: TWO) has operated as a mortgage REIT since 2009 and primarily manages residential mortgage backed securities, residential mortgage loans, residential real properties and other financial assets. The company is externally managed by PRCM Advisors LLC, a wholly-owned subsidiary of Pine River.
Two Harbors' investment portfolio as of Dec. 31, 2012 is very well diversified, giving the company an edge over American Capital Agency (NASDAQ: AGNC), Annaly Capital Management (NYSE: NLY), Armour Residential REIT (NYSE: ARR) and MFA Financial (NYSE: MFA).
Figure 1 above shows the proportion of Agency residential mortgage backed securities to non-Agency RMBS in the company’s entire assets portfolio. It is evident from the graph above, Two Harbors has a large amounts of Agency RMBS in its portfolio, while high yielding non-Agency RMBS form 19% of the portfolio. At the end of the fourth quarter, the company’s Agency MBS yielded 2.9%. In contrast, its non-Agency MBS yielded 9.5%. A closer look at the types of securities held by the company reveals fixed rate securities constitute 80%, while 20% of the entire asset portfolio is adjustable-rate securities.
While Two Harbors primarily operates as a mortgage REIT, it has initiated acquiring residential real properties across the United States. It has plans to hold these properties for future investments and rent them out for income like an equity REIT.
Therefore, Two Harbors provides its investors complete diversification within the REITs sector of the United States.
During the most recent quarter, the company earned 2.9% net interest rate spread. This is compared to the 3.1% spread earned during the linked quarter of 2012. This is the spread between what Two Harbors earned on its interest yielding assets and what it paid on its interest bearing liabilities.
At the end of the fourth quarter, Two brought down its debt-to-equity ratio to 3.4 times, against 3.8 times at the end of the third quarter. Keeping lower levels of leverage in such challenging times is advisable.
During the quarter, Two Harbors used interest rate swaps with a notional principal of $19 billion, of which $17.5 billion was utilized to economically hedge interest rate risk associated with the company's short-term LIBOR-based repurchase agreements.
During the fourth quarter, the prepayment speed for Two’s Agency MBS holdings was 6.6%, while it was 3.2% for its non-Agency MBS holdings. Since the Agency MBS are purchased at a premium to their par values, they experience much higher prepayment speeds, compared to non-Agency MBS, in the event of decreasing interest rates.
The company announced $0.55 per share as quarterly dividend for the fourth quarter of 2012. Since it was the last dividend of the year, it was intended to distribute the remaining REIT taxable income earned during 2012, including the taxable income earned from Silver Bay Property Trust. This is compared to $0.36 per share dividend for the third quarter of 2012.
Going forward, I believe investors should not expect a “significant” decline in the quarterly dividends of Two Harbors. This is, say, after looking at the upward trend in the mortgage rates in the US. Rates have continued their upwards journey since the beginning of the year, and I believe this will help support the company’s net interest spread and dividend distribution.
According to the data provided by Reuters, 43% of the analysts covering the stock recommend investors buy Two Harbors, while 36% rate the stock outperform. The remaining recommend investors hold Two in their portfolio and benefit from its elevated dividend yield, while none of them have a sell opinion.
The company has an attractive valuation compared to most of its peers in the US. Two Harbors is currently trading at an 8% premium to its book value, while American Capital Agency, Armour Residential and MFA Financial are trading at a 3%, 1% and 28% premium to their respective book values. In contrast, Annaly Capital Management is trading at a 4% discount to its book value.
MFA Financial has been in business since 1998 and seeks to invest in both Agency and Non-Agency MBS. At the end of the third quarter, around 60% of the company’s asset portfolio was invested in Agency MBS, while the rest is non-Agency. Most of the non-Agency MBS are purchased at discounts to their par values and are considered very high quality. Within the Agency MBS, the company has a large concentration in 15-year fixed rate securities, which increases the prepayment protection, however a majority of it is not eligible for HARP. The company reported CPR of 21.6% for the third quarter, up from 20.4% at the end of the second quarter. MFA is currently yielding 8.9% and is trading at a 28% premium to its book value.
In contrast, American Capital Agency, Armour Residential, and Annaly Capital Management invest exclusively in Agency mortgage backed securities. American Capital’s recent earnings were positively impacted by a hike in asset yields, supported by a hike in the interest yielding assets during the quarter. Asset yields increased despite the challenging micro-environment, where the Fed is committed to keep the rates low and the yield curve flat. American Capital is believed to be a highly prepayment protected portfolio, like Armour Residential. Armor Residential is offering a dividend yield of 13.6%, while it is trading at 7% premium to its book value. Armour Residential has a large concentration in 15-year mortgage backed securities. In contrast, Annaly Capital has a large concentration in 30-year MBS. Annaly Capital’s asset yields and net interest spread were compressed again during the most recent quarter. However, the management managed expenses well during the fourth quarter, which is why they declined 36%.
I reiterate my bullish stance on Two Harbors. For the full year 2012, Two Harbors delivered a return on book value of 47% as measured by dividends declared and book value appreciation. The company is believed to have a very well diversified business mix, well supported by its financials. The hike in mortgage rates further eliminates the threat of any significant dividend decrease, which is why I believe a majority of the analysts covering the stock are supporting my bullish stance on Two Harbors.
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