Why I Bought Hatteras Financial

By Chad Henage - August 29, 2012 | Tickers: NLY, CMO, CIM, HTS | 0 Comments

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I'll admit up front that I was hesitant to jump on the real estate REIT bandwagon for a little while. Initially, I didn't want to believe that these companies could successfully navigate the huge leverage required to pay out double-digit dividend yields, and not implode if short-term rates rose. However, I came to my senses about a year ago, and realized that short-term rates were likely to stay low for a while. One of the companies I chose to invest in was Hatteras Financial (NYSE: HTS). This was primarily due to the company's unique investment portfolio and the strategic advantage that I believe it offers.

Unfortunately, most investors look at real estate REITs and assume that each of the companies do exactly the same thing. However, nothing could be further from the truth, as on a company to company basis there are significant differences in their portfolios. For point of reference, consider that Annaly Capital (NYSE: NLY) focuses primarily on fixed-rate agency securities and tends to hold longer-term mortgage assets. A subsidiary of Annaly, Chimera Investment (NYSE: CIM) tends to hold non-agency securities, which carry higher risk due to the lack of government backing. A third type of company is Hatteras Financial and their counterpart Capstead Mortgage (NYSE: CMO), which both focus on adjustable-rate securities. The point is investors need to know that each company's risk differs tremendously depending on what is in the company's portfolio. The fact that Hatteras focuses on adjustable-rate securities is an advantage as far as I'm concerned, and offers somewhat of a hedge against the potential rise in interest rates.

Not long ago Hatteras reported earnings, which gave investors a chance to examine the company's portfolio and growth. Besides the fact that the company focuses on adjustable-rate securities, another difference between Hatteras and other real estate REITs is the company's distribution policy. Most other REITs routinely distribute 90% of their taxable income to maintain their tax advantaged status. Hatteras on the other hand, expects to distribute 100% of their taxable income after, “application of available tax attributes.” Looking at the company's recent earnings report shows results that investors should be pleased with. Mortgage-backed securities increased by more than 26% in the last 6 months, which led to total interest income up 13.78%. While interest expense did increase, the company still reported net income up 14.96%. In addition, the company's portfolio composition looks attractive given the future uncertainty of interest rates.

More than 92% of the company's portfolio is invested in adjustable-rate agency securities. The small percentage of the portfolio invested in fixed-rate securities are all based on a 15 year amortization keeping interest rate risk as low as possible. The company is further attempting to manage interest rate risk with over 70% of the portfolio invested in securities that reset their interest rate between 37 and 84 months. In plain English, the company prefers to invest in adjustable-rate mortgages with a fixed-rate portion between 3 and 7 years long. Since it's quite certain that long-term rates will rise over time, this shorter term duration in the company's portfolio should help Hatteras. The company can reinvest funds at these higher rates down the road. While the company's focus on shorter term securities does cut the companies average coupon rate, this is an acceptable trade-off to avoid the huge interest-rate risk that a fixed rate 30 year security represents. As proof that the company can profit even if interest rates change, consider that an increase in short-term interest rates of 0.50% would only decrease net interest income by 2.25%. Even if short-term rates rose by 1%, net interest income would decrease by less than 8%. Both of these assumptions are significantly less than six months ago, and show that the company is using its hedging strategies wisely. Realistically, the main reason most investors consider real estate REITs is for their potential dividend yield.

Using the same companies we looked at before, take a look at the difference in their expected yields if each company meets expected earnings, and pays out their traditional percentage.

You can see that among the four companies, at first it appears that Chimera would be the best investment. However, the company's higher indicated yield also comes with the additional risk of the non-agency securities that Chimera holds. Where Annaly is concerned, while the company's future indicated yield is the lowest of the four, keep in mind this company also has the most seasoned management team and a good track record of navigating different interest-rate environments. The choice between Hatteras and Capstead is pretty straightforward. Hatteras is expected to pay out a higher yield in the future. As long as both companies have equal access to the same types of investments, the higher payout percentage makes all the difference. Given that the Federal Reserve expects to keep short-term interest rates low well into 2013, it seems real estate REITs should continue to do well. In my estimation, Hatteras will have an easier time adjusting its portfolio if short-term rates rise because of the adjustable rate securities it holds. For investors looking for a high-yield REIT with future interest-rate protection, Hatteras seems the ideal candidate.

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