TWO - Two Harbors Investment: Mark-To-Market Books Can Be Deceiving

2023-09-11 06:07:33 ET

Summary

• Two Harbors Investment Corp. has experienced a decline in book value per share due to rising interest rates and mark-to-market adjustments.
• The future performance of Two Harbors will be heavily influenced by the trajectory of interest rates, but there are signs of inflation cooling which could reduce interest rate volatility.
• The new dividend level appears to be more sustainable and better covered by earnings.

Two Harbors Investment Corp. ( TWO ) is a mortgage real estate investment trust (mREIT) specializing in investment in US agency backed mortgages. Like most mREITs involved in this space its book value per share has declined in recent months with the rise in interest rates and associated mark-downs in mark-to-market values of its assets. The risk of further rate increases is likely to remain the single biggest factor influencing the share price in the months ahead. However, with some early signs of inflation cooling there is a greater likelihood of interest rates remaining stable and consequentially resulting in a less-pronounced negative impact on Two Harbors’ portfolio.

Two Harbors’ portfolio

Two Harbors’ portfolio is dominated by agency-backed mortgage backed-securities ((MBS)) which makes up around 73% of its portfolio with the remainder largely being mortgage servicing receivables ((MSR)). The MBS market has been negatively impacted by several factors, key among them being the rising rate environment and concerns over the US Federal Reserve potentially selling down its mortgage portfolio. Late last year, Wellington Management noted the lively discussion in the market regarding the possibility of the Fed selling mortgages outright. However, they believe that Fed Chair Powell's statement during the September FOMC meeting has put an end to this speculation, as he mentioned that it's not currently under consideration and not expected to be in the near future.

The Fed's reasoning includes the significant increase in mortgage rates, which has led to a notable slowdown in the housing market. Consequently, there may not be a pressing need for further tightening, especially considering the potential risks of such an unprecedented move outweighing the probable benefits. Wellington Management expressed the view that the Fed will likely continue to rely on interest-rate hikes as the primary means to tighten financial conditions. Nevertheless, these concerns have likely contributed to increased volatility in the MBS market as some Fed officials continue to express the view that the MBS portfolio needs to be wound down more rapidly.

Despite these concerns there have been some more recent positive signs pointing towards reduced volatility in the MBS market. Management recently indicated that reduced volatility in the MBS market was a key contributor to its earnings beating expectations. This slowdown in volatility was largely attributed to the resolution of the debt ceiling crisis in Washington and “the well-contained path of Federal Reserve rate hikes”. In my view, this recent reduction in volatility in the MBS market is likely to remain for the time being as various uncertainties in the market have been addressed. However, this could change quite quickly if the Fed indicates an expectation of more aggressive rate hikes in the quarters ahead.

Higher interest rates are also not universally bad for Two Harbors as it reduces the risk of early repayment in its MSR portfolio. Given the current higher than average interest rates on mortgages, mortgage holders are less likely to refinance at a lower rate than they currently have. Management also expects the rate of early repayments to slow down further in the third quarter which is accretive to its MSR portfolio. Declining interest rates could increase the risk of early repayment here somewhat but not to the same extent that declining interest rates would positively impact the value of its much larger MBS portfolio. Therefore, a decline in interest rates would be a net positive for Two Harbors. In my view, the Fed rate hike cycle has likely reached its peak for now in light of the recent cooling in inflation. A more stable interest rate environment certainly reduces the risk of further mark-to-market write-downs in Two Harbors’ portfolio.

Earnings drivers and the dividend

Much of the recent losses recorded by Two Harbors are mark-to-market losses which arise as the mREIT needs to value its MBS portfolio at current market value. The core business has largely continued to perform well with interest income increasing from $116.6 million in the prior quarter to $117.8 million in the second quarter. Nevertheless, the mREIT has also seen a fairly substantial rise in funding costs which has adversely affected its net spread. Investors in Two Harbors will need to pay attention to the net spread in quarters ahead as it could potentially have an extremely negative impact on earnings if this spread declines further.

Two Harbors currently offers a forward dividend yield of around 13.39% which places it around the middle of the pack on the list of mREITs in the peer comp charts below. The current dividend appears to be well-covered by earnings but it does follow a dividend cut this quarter.

In the second quarter the dividend was cut from $0.6 per share to $0.45 per share. This dividend cut was not entirely unexpected given the ongoing volatility in the MBS market and the associated decline in book value. However, management has indicated that –

Importantly, this decision was neither a reflection of downward pressure on current earnings nor our earnings outlook. We believe that the current investing environment for Agency RMBS and MSR is very attractive and retaining additional capital to put to work should result in positive returns. Further, by definition, reducing the dividend will allow more of an opportunity for book value to increase, which we also view as positive for shareholders.

The new dividend is certainly covered much better by earnings with the mREIT reporting income excluding market-driven value changes of $0.6 per share. The old dividend would have consumed all of these earnings whereas the new dividend is covered by earnings at a rate of 133%. Nevertheless, the Mreit has had several dividend cuts in recent years which might be concerning to investors seeking dividend stability. That being said, I am of the view that the now-lower dividend is more sustainable than the previous dividend.

Valuation

Two Harbours is trading at around 0.81 times its book value which is the second highest of the mREITs considered in the peer comp charts below. This higher than peers price to book value likely arises from the markets confidence in the overall quality of its portfolio. The current price to book value is also below its historical levels with its 5-year average price to book value being around 0.91.

The lower price to book value at the moment is largely driven by the interest rate risks associated with its portfolio. Given current market conditions this slight discount is not unreasonable and does not suggest that the stock is substantially undervalued. In my view, the stock is trading near fair value in the current market. There are limited near term catalysts that could see the stock rerating to its historical average price to book value other than a stabilization and potential decline in interest rates.

Conclusion

Two Harbors operates in a challenging environment due to the recent rise in interest rates. This has led to a decline in its book value per share, reflecting mark-to-market adjustments on its assets. The future performance of Two Harbors will likely be heavily influenced by the trajectory of interest rates. However, there are early signs of inflation cooling, which may lead to more stability in rates, potentially mitigating the negative impact on the company's portfolio.

The recent dividend cut was also not entirely unexpected and reflects management's strategic approach to retain capital for reinvestment, potentially leading to positive long-term returns. The new dividend level appears to be more sustainable and better covered by earnings, which may provide investors with a more stable income stream. However, this dividend cut coupled with previous dividend cuts could see some income investors shy away from the stock.

In terms of valuation, Two Harbors is currently trading at a slight discount to its historical average price-to-book value. This discount is primarily attributed to the interest rate risks associated with its portfolio. While the stock may not be substantially undervalued, it is trading near fair value given the prevailing market conditions. Absent significant catalysts, such as a stabilization or decline in interest rates, it is likely to remain within this range and leads me to assign a hold rating to the stock at this point in time.

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