Two Dividends With Smart Double-Digit Yields
Elise is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
If you’re an income investor, you’ve been badly pinched in the last few years. It’s difficult to find promising yields when the 10-year U.S. treasury rates have been below 2% over the last five months compared to the long-term average of 6.67%. One area that has continued to shine is mortgage REITs. The most successful of these have delivered value by increasing their market capitalization and by delivering double digit dividend yields as they shell out 90% of their taxable income to their investors.
Their business model is relatively simple: they borrow money at low rates to fund assets that pay out higher rates. The devil is obviously in the details. These investments carry specific risks such as being able to maintain the interest rate spread, prepayment of loans, and defaults of loans. Each trust has its own approach to the risks. Annaly Capital (NYSE: NLY) and the American Capital Agency (NASDAQ: AGNC) invest only in assets that are backed by federal agencies. Capstone Mortgage (NYSE: CMO) specializes only in ARMs, and Redwood Trust (NYSE: RWT) deals with jumbo loans. Two Harbors Investment (NYSE: TWO) is a relatively new entrant into the field and offers a thoughtful blend of assets backed up by exciting state-of-the-art analytics.
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Interest Rate Spread
Of course, one of the most important factors in this line of business is being able to develop the widest spread between borrowing and lending interest rates. Because of easing by the Federal Reserve (and the potential for more), the “yield curve” has flattened and it is becoming more difficult for these REITs to maintain their profitable spreads. Two Harbors spread is more than twice as high as the other REITs in the comparison group because of their combination of agency-backed and higher-yielding (but riskier) non-agency securities.
Risks of Prepayment and Default
Naturally, these assets carry more risks: particularly risks that people will prepay their loans (perhaps by refinancing) or that, in today’s era of high unemployment and depreciated house prices, that they will default. Their investor relations’ presentations highlight how Pine River Capital (the external managers and advisers to Two Harbors) is cleverly managing these risks through data analytics. They still expect strong returns even under the worst-case scenario that 80% to 90% of subprime mortgages default, and in the case of liquidations only 25% of a loan is recovered. In addition, they are analyzing vast quantities of data to predict prepayment behavior of individual borrowers. Naturally, there’s little information about the processes being used (other than that the hired mathematicians and statisticians in China to do it), but with what I’ve seen accomplished through methods such as Bayesian networks and “Random Forests,” the problem is tractable and potentially highly profitable.
Finally, Two Harbors (through Silver Pay Property Management) is beginning to purchase and manage residential real estate in markets that have suffered the most depreciation: i.e. Arizona, Florida, Nevada, etc.. While this still represents a small portion of their overall asset structure, it shows a willingness to move into new areas that should bring profit as the REITs lose their performance but housing prices recover from their bottoms.
I am intrigued by Two Harbor’s smart approach to the REIT business. It has increased its market capitalization by 2,000% since it formed three years ago and it has done this with lower leverage than other REITs. It’s currently offered at a higher Price to Book ratio than its competitors but I still think it’s worth your look.
Elise does not own any shares in the companies mentioned. The Motley Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.