TWO - Two Harbors Is Stabilizing

2023-10-31 17:48:35 ET

Summary

• Two Harbors Investment Corp. saw its dividend cut by 25% again this year as we predicted due to the volatile and challenging operating environment for mREITs.
• The company's acquisition of RoundPoint Mortgage Servicing LLC is expected to add $25-30 million to earnings in 2024, which is seen as a bullish.
• Despite the challenges, the dividend seems secure due to widening spreads, the performance of the MSR port, and the new acquisition.

When we last covered Two Harbors Investment Corp. ( TWO ) stock we told you that we were avoiding the name because "the dividend was still in jeopardy ." Sure enough, the dividend was cut 25% to $0.45 in the summer of this year. The massive and rapid move in rates has caused havoc for mREITs. The situation is still precarious, but we see rates stabilizing next year as the Fed's rate hiking campaign, in our opinion, is stabilizing. The yield curve is starting to un-invert, and that causes some short-term pain but ultimately we want to see the environment get back to a normal yield curve, and mREITs can handle that situation with much more relative ease.

Of course, with high rates, prepayment risk has declined as refinancing is simply a poor option for many due to higher rates, but the spreads have been volatile and we have seen weight on book values for the sector. With that said, Two Harbors j ust reported Q3 earnings and they seem to show stabilization, and the stock is getting a bounce. While we are not diving in, the situation is improving.

To be clear, the Agency RMBS market remains a rough operating environment as rates are volatile. Mortgage servicing rights have seen mixed performance. Spreads have tightened in recent quarters and that had helped book value after book values took it on the chin. 2023 has been horrible for mortgage real estate investment trusts, or mREITs, as now the income they offer carries risk and investors can enjoy parking in cash or bonds and simply collect. Every time the ten-year spiked in yield, income names for the most part got nailed. This tough 2023 follows 2022 which was one of the most challenging years for this sector in decades. In Q3, we saw both higher rates and higher volatility combined to see mortgage spreads widen again and that negatively impacted book value and returns. One big move Two Harbors made was finalizing the acquisition of RoundPoint Mortgage Servicing LLC. Management is forecasting that by bringing this servicing in-house it can add $25-30 million to earnings in 2024. That is bullish.

So as rates kept climbing, Two rolled into higher coupons, while the MSR port is hanging in there. Comprehensive income came in at another loss. Those losses were $56.8 million or $0.61 per share and this compared to gains of $31.5 million in Q2. What about leverage? Their coupons are far out of the money, which should allow stable returns, barring massive moves in rages, yet the leverage is up. Total debt-to-equity widened to 5.2X from 5.0X in Q2, and is up from 4.4X to start 2023. Net interest income slipped negative to a loss of $49.5 million. Pretty mixed, but it is about where things are going, and the outlook looks stable. Moreover, the dividend seems covered.

Dividend coverage

mREITs are getting more and more calculated in determining whether their dividends were covered. Net interest income has been for many quarters in this environment. While the portfolio is stabilizing, earnings available for distribution were a loss of $0.01, which is what the sector had been reporting. However, income excluding market drive changes in value or so called "IXM" was $0.51 per share. We would prefer to see simpler (though still a non-GAAP measure) of distributable earnings cover the payment, but it is expected that this figure will now continue to diverge from earnings power as it does not capture hedging derivatives and weights yield to maturity at purchase. As of now, we think the dividend is secure given that spreads are widening, the performance of the MSR port, and their new acquisition.

The spread widened from Q2 hitting book value

The spreads have been so volatile, first widening, then narrowing significantly, and now widening again as the pace of rate increases has slowed to a degree, though now we have un-inversion happening in Q4. That said, in Q3, the annualized yield on the company's portfolio assets was 5.45%, where was total financing costs were 5.26%, netting a spread on the port of 0.19%. That widened from 0.16% in Q2. Two Harbors' book value has been getting crushed for many quarters, though started to bounce back some when spreads narrowed.

Here in Q3, book was reported at $15.36 compared to $16.39 at the end of the second quarter. The movement in spreads impacted the book value. We think we see real stabilization in book value in 2024 because rates should be less volatile. Shares are currently at a $3.75 or 24% discount to book. Before today's rally, shares were at over a $5 discount.

Final thoughts

The Two Harbors Investment Corp. dividend was cut as we predicted. Now, there are added layers of financial accounting, with $0.51 suggested as coming in despite distributable earnings being negative. Spreads are widening, and the company's portfolio should do well in this environment going forward. We like the in-house for servicing with the recent acquisition, and the big discount gives a margin of safety. However, rate volatility is the enemy of returns, and if we see the curve simply stabilize in 2024, TWO stands to see strong returns on its portfolio. We think Two Harbors Investment Corp. stock is risky, and remain neutral, but this outcome and forward look from management was welcomed.

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