Description

This idea is for yield oriented investors looking for attractive yields with a potential for capital appreciation. It’s been a while since Two Harbors (TWO) was written up on VIC. We believe it’s a good time to go long TWO.  Prices have dropped from at 52-week high of $16.27 in the summer of 2018 to a recent low of $12.06, which is when we started writing this up. The stock has run up a bit since then and currently sits around $12.60. The drawdown in TWO’s stock price has been much worse than the performance of it’s peer Annaly Capital Management, Inc. (NLY), the industry bellwether, which is down about 15% from its 52-week high and the mortgage REIT industry ETF, iShares Mortgage Real Estate Capped ETF (REM), which is down about 8% from its 52-week high.

We feel the drop in TWO’s price is overdone, especially relative to the sector. Part of the downturn has been driven by fears of a dividend cut as the yield curve has inverted and long term rates have dropped, creating concerns about increases in prepayments and net interest margin compression.  While TWO will need to reduce their dividend in the upcoming 6/30/19 quarter from $0.47 in 1Q19 to approximately $0.41-$0.43, the new dividend will annualize to about 13%-13.5% yield compared to the current implied yield of 14.9%. The 13%-13.5% yield is a very attractive yield on an absolute basis but also on a relative basis compared to the industry average hybrid mortgage REIT (mREIT) yield of 12%.  Moreover, TWO runs a very well-hedged book that limits book value volatility with various interest rate hedging instruments so book value is relatively stable compared to many of the other mortgage REITs in the industry. The book value as of 3/31/19, was $13.83 per common share. Given the recent management commentary about the April and May book values being generally flat, we are estimating that the book value is generally flat as of today.

As the leading hybrid mortgage REIT in the industry, TWO has generally garnered a premium valuation relative to peers and a premium to book value.  At a valuation of 1.05x book value and relatively stable book values, we are estimating a 12 month target price of $14.52, a 15% capital appreciation from today’s prices.  Together with a 13% yield, we are projecting a total return over the next 12 months of 28% as a base case. In an upside scenario, we can foresee TWO trading at a premium to book value of 1.1x, which it has done in the past.  That would mean a stock price of $15.20 and capital gains of 21% if we assume stable book values, for a total return of 34%. The way we are thinking about a downside scenario, TWO is currently trading at .91x book value. If we collect at 13% yield over the next 12 months, the stock would have to trade down 13% (via a mix of book value decline and/or a contraction in valuations) in order to break even.  Given the current discount to book value and the high yield, we like the margin of safety. Obviously, there are some outlier scenarios on the downside and upside that could generate outcomes outside of this range but we’re comfortable with the return potential relatively to the distribution of future outcomes.

Investment Highlights

1. Strong Management

TWO is externally managed by a well-regarded hedge fund, Pine River. Generally, internally managed REITs garner a higher valuation than externally managed REITs. However, in this case, as owners of TWO, we get to leverage the know-how and expertise of Pine River, which has a good track record across a number of other investment vehicles. https://twoharborsinvestment.com/company/external-manager/  Because of the long track record of good performance, TWO is generally perceived as one of the leaders in the mortgage REIT space and has often traded at a premium to book value. The chart below illustrates the total return of the stock since inception:

2. Differentiated Investment Strategy

Two has undergone a transformation over the course of the last few years. When it was first formed around the time of the financial crisis, TWO purchased distressed subprime mortgages at a steep discount, a great investment in hindsight. It also started a division that purchased single family houses at distressed prices and played the recovery in home prices.  Subsequently, this division was spun out and became a separately traded SFH rental business called SilverBay. In 2017, TWO also spun out a commercial real estate focused mortgage REIT that now trades as a separate publicly traded mRET called Granite Point Mortgage Trust Inc. (GPMT). TWO has successfully created value throughout its inception as a public company being both opportunistic and strategic about allocating capital to high-return opportunities in the real estate sector.  

At this point, the distressed subprime non-agency mortgage investment has largely played out as house prices have recovered since the financial crisis and the non-agency mortgage prices have traded up and the pool of non-agency mortgages have dwindled.  While TWO still owns subprime non-agency mortgages, it is now a much smaller portion of the portfolio. As that part of the portfolio has shrunk, TWO has now transitioned to a different the portfolio mix that is comprised mostly of agencies mortgages paired with mortgage servicing rights (MRS), as shown below. TWO is unusual in the mREIT sector in using a large portfolio of MSRs for hedging purposes. This paired strategy allows TWO to earn a mid-teens ROE, which is higher than many other mREITS, because the paired mortgage asset + MRS reduces hedging costs versus hedging only with interest rate hedging instruments.

From the following company presentation slides, we can see how TWO is differentiated from other mREITs in the industry and deserves a premium valuation given the more attractive strategy and the good long term track record:

KEY DIFFERENTIATING FACTORS

1. Strategy of pairing MSR with Agency RMBS

2. Utilize a variety of instruments to hedge interest rate exposure

Goal is to deliver strong results and book value stability through a variety of market environments

ATTRACTIVE SCALABLE INVESTMENT OPPORTUNITY IN PAIRING AGENCY RMBS WITH MSR RATES STRATEGY - Combination of Agency RMBS and MSR

• Expect returns in mid-double digits for Agency RMBS paired with MSR

• Believe the combination of these two assets results in a higher return with a lower risk quotient

• Long runway to this strategy, due to robust transfer market for MSR

CREDIT STRATEGY - Legacy non-Agency securities

• Discounted legacy non-Agencies continue to benefit from residential tailwinds that support strong total returns

• Baseline returns to lower priced bonds in high single digits; upside price appreciation can drive total returns in low-to-mid double digits

• As deeply discounted legacy non-Agency securities realize their upside potential, expect to recycle capital into the best market opportunities available at the time

3. Attractive Valuation and Yield

With the stock around $12.60, TWO is trading at .91x of our estimated book value of $13.83. The .91x valuation is a discount to the hybrid mortgage REIT average valuation of .95x.  Our estimate is based on management commentary about April and May book values being flat since 3/31/19, when the reported book value was $13.83. Throughout the trading history of TWO since inception, TWO has generally traded at a premium to book value because of a number of factors: (1) good track record of total returns and value creation, (2) good management, including great disclosure and investor relations, (3) relatively stable book values, (4) attractive yields, and (5) good liquidity relative to the other names in the sector.  There was a brief period in early 2016 shortly after the markets freaked out that the Fed had finally raised rates by 25 basis point from the zero bound at the Dec 2015 Fed meeting. The entire sector traded at the steepest discount to book value since the financial crisis for a short interlude, but that ended up being an exceptional buying opportunity. Otherwise, TWO has generally traded at a premium to the sector and often at a premium to book value.

We expect a dividend cut in the 6/30/19 quarter from $0.47 to something in the range of $0.41-$0.43. At the midpoint of this range, the yield would be about 13.3%.  This is a premium to the hybrid mortgage REIT average yield of 12%. We currently expect the dividend to be reasonable stable at this level over the next 12 months. The current quarterly dividend rate of $0.47 implies an annual yield of almost 15%, which is way above the yield of the other mortgage REITS, so investors are baking in some sort of a dividend reduction. A number of other mREITs have already announced or taken a dividend reduction so some dividend reduction for TWO is largely expected.  However, we feel an annualized 13.3% yield based on our estimated dividend cut in 2Q19 is reasonably maintainable for the next 12 months and still attractive on an absolute and on a relative basis. The chart below shows the book values and current yields of the hybrid mortgage REIT sector:

4. TWO is Good at Managing Risk

TWO has generally done a good job in managing risk and maintaining stable book value over time.  Much like banks and other financial institutions, mortgage REITs run a levered book of mortgage assets, in which they are borrowing short term and lending long term. However, the mortgage REITs differ from banks in their interest rate and spread hedging strategies. TWO is one of the best in the mREIT sector in managing interest rate and spread risks.  Most other mREITs hedge using interest rate swaps, swaptions, caps and forwards. Some actively trade assets and adjust hedges around intra-quarter more than others. However, what really sets TWO apart is their strategy of pairing their mortgage assets with mortgage servicing rights (MSR), in addition to using the traditional mREIT hedging tools. Pairing mortgage assets with MSRs creates an inexpensive hedge against interest rate risk and the risk of mortgage spreads widening.  MSRs go up in value as interest rates rise whereas mortgages drop in value as interest rates rise. In addition to hedging interest risk, MSRs also hedge against mortgage spreads widening because they are referenced off of mortgages and not just interest rates like the other interest rate hedging instruments.

The chart below from the company presentation shows the risks to book value and net income for different interest rate moves across the curve (assuming parallel moves across the curve):

Because TWO is generally well hedged against interest rate and spread risk, stable interest rate environments (or at least not highly volatile interest rate environments) are usually best for generating returns and maintaining stable book values. Obviously, like banks and other financial institutions that borrow short and lend long, inversion of the yield curve isn’t good for net interest margin and generating net interest income. If the inversion lasts a long time, net interest margins will compress and hurts yields and valuations. Currently, the yield curve is already inverted in the 3mo-10 yr parts of the curve. We expect the inversion to moderate and reverse over the next 12-18 months, creating a tail wind for TWO as spreads are likely to improve. The market is already pricing in a 100 bps cut in the Fed Funds rate by the end of 2020.

Catalyst

- Quarterly dividends, yielding 13%+ annualized.

- Continued stable book values.

- Yield curve inversion reverses.