AGNC - Two Harbors Investment: Net Spread Trails Peers

2023-06-28 13:29:53 ET

Summary

• Two Harbors Investment is a mortgage REIT that primarily invests in residential agency mortgage-backed securities and mortgage servicing rights.
• TWO's book value has held up better than other mortgage REITs due to its MSR investments, which tend to perform well in a rising rate environment, offsetting declines in its agency MBS portfolio.
• However, TWO has underperformed in net interest spread and had to reduce its quarterly dividend by 25%.

Two Harbors Investment ( TWO ) is cheap trading at a big discount to book, but it hasn’t managed net interest spreads as well as some of its peers.

Company Profile

TWO is a mortgage REIT that primarily invests in residential agency mortgage-backed securities ((RMBS)) and mortgage servicing rights ((MSR)). It then leverage up to further enhance returns.

For its RMBS portfolio, the firm invests primarily in MBS whose principal and interest payments are guaranteed by a U.S. government agency, such as Ginnie Mae, or government-sponsored enterprises, such as Fannie Mae and Freddie Mac. Investments in these agency securities have virtually no credit risk.

TWO also owns a portfolio of MSR investments, which allows it to control the servicing of the loan and the right to collect fees for collecting principal and interest from a borrower and distributing those payments to the owner of the loan. TWO actually doesn’t perform these services, instead contracting them out to sub-servicers, it just owns the rights.

Structured as a REIT, it pays no taxes at the corporate level and is required to pay out 90% of its earnings to shareholders in the form of dividends. It also employs an active trading and hedging strategy.

At the end of Q1 2022, TWO's investment portfolio was valued at $15.8 billion, with $12.4 billion of that Agency MBS and TBA securities, and $3.1 billion in MSR.

Opportunities & Risks

Like other firms that invest in agency residential mortgage backed securities, TWO’s RMBS portfolio is a spread business. It uses short-term funding vehicles, like repos, and then leverages up to purchase mortgage-backed securities.

With a portfolio consisting of agency, TBA, and MSR securities, AGNC faces minimal credit risk, although MSRs have default risk in the context of loss of service fees and a higher cost to service the loan if it defaults. The firm faces other risks as well, such as interest rate risk, spread risk, and prepayment risk.

Interest rate risk is the main one that has been hurting mortgage REITs in the current rising interest rate cycle. The reason is that as the coupons on new mortgages are set higher, the value of older MBS with lower coupons decline, impacting the value of their portfolios, and their book values. At the end of Q1 2023, about 99% of the market value of AGNC's RMBS portfolio was in 30-year fixed MBS.

Like other mortgage REITs, TWO has been moving to higher coupon MBS. At the end of Q1, 93% of its 30-year RMBS portfolio had a coupon of 4.5% or higher, 60% of the portfolio had coupons 5% or above, and 27% of the portfolio had coupons of 5.5% or above. In addition, 77% of TBA investments were at coupons of 5% or above.

Now this didn't help stop the decline in its book value, which went from $23.40 (split adjusted) at the end of 2021 to $17.72 at the end of 2022, a -24% decline. However, the decrease was less than many other mortgage REITs, due to its MSR portfolio.

TBV did increase over 8% in Q4 compared to Q3 when TBV was $16.42. In Q1, book value declined once again, falling -7% to $16.48.

Spread risk is another concern for mortgage REITs. When the spread between borrowing costs and MBS tightens, firms earn less spread income. At the same time, wider spreads between the value of Treasury securities and MBS can hurt book value.

TWO also face risks in a dropping rate environment through prepayment risk. This happens when people refinance their mortgages. Prepayments will always happen, as people move and payoff their mortgages as well, but in lower rate environments the pace tends to accelerate more than expected. Given its investments in mortgage servicing rights, when a mortgage is paid off, TWO loses the income stream from that loan. MSR values can increase in a rising rate environment, as there is less refinancing, extending the duration of the loan and thus income stream potential.

Discussing the current dynamics of its MSR portfolio on its Q1 earnings call , CEO William Greenberg said:

“I'd like to change gears and expand upon a subject that may be underappreciated in the market, which is the float income component of MSR. Float income refers to the interest that is earned on principal and interest and taxes and insurance before those monies need to be remitted to the relevant investors. While MSR and fixed coupon interest-only or IO bonds, share many similarities and risks, MSR is not a bond. It has important additional cash flows that include cost of service and compensating interest, which detracts from the overall cash flow as well as additive cash flows like float income, late fees and ancillary income and recapture. In different interest rate environments, these components will add more or less to the value of servicing. … At very high rates, the prepayment speeds can't go any slower, which ultimately results in an IO acquiring positive duration and decreasing in price as rates increase. In contrast, the float components of MSR behaves differently. …

"The price goes up for 2 reasons as rates rise. First, like in IO, MSR extends as rates rise and prepayments slow, causing the price to rise. Second, as rates rise, the effective coupon of float income also increases since the cash flow is based on the short-term earnings rate on those custodial balances. At very high rates, even when the prepayment speeds can't slow anymore, the effective coupon of this component continues to rise, which causes the price of this component to continue to increase.”

Conclusion

TWO’s book value has held up better than other mortgage REITs I’ve looked at including AGNC ( AGNC ), which I last wrote about here , and Annaly ( NLY ), which I wrote about here . This is due to its MSR investments, which tend to perform well in a rising rate environment, offsetting some of the declines in its agency MBS portfolio.

However, one area where TWO has underperformed is with its net interest spread, which fell to 0.52% in Q1 versus 1.62% for NLY and 2.88% for AGNC during the same period. This comes down largely to hedging to keep funding costs down, and TWO management hasn’t been as strong as its peers on this front.

As a result of its weak net interest spreads, TWO also had to reduce its quarterly dividend by -25% to 45 cents a share. Its yield is now about 13.3%. It was the right move given its current circumstances.

For mortgage REITs, I usually look at a price to book as the best way to value them, and on that front TWO is the cheapest, trading at 0.82x. BY comparison, AGNC trades at 1.08x, NLY trades at 0.99x, and ARMOUR ( ARR ) is at 0.97x.

Given its discount to book and its peers, TWO could have some good potential upside, but its portfolio also might not have the pop like AGNC and NLY when the cycle shift given its fairly large MSR portfolio and its higher coupon investments. As such, given its valuation and the point in the cycle, I think it’s okay to “Hold,” but I view AGNC and NLY as more attractive options.

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