TWO - Two Harbors Preferreds: An Arbitrage Opportunity

2023-03-10 04:56:53 ET

Summary

• With the Fed posturing more hawkish about interest rates, investors may do well to go on offense and improve their portfolio yields.
• Pricing inversions in preferred shares can present arbitrage opportunities.
• This article describes the opportunity we see today in the Two Harbors' preferreds.

Back in February 2012 I submitted my first article to Seeking Alpha: Pricing Anomalies in Pari Passu Preferreds Present Fleeting Opportunities. The alliteratively titled piece described my observations that two nearly identical equity issues, from the same company, were trading at disparate prices and that investors could improve both their yield and cost by swapping one issue for the other.

In today's crazy markets, similar situations seem to have become more frequent, sustaining, and actionable on a more meaningful scale. As empirical examples, I offer Two Harbors Investment Corp.'s ( TWO ) preferred B ( TWO.PB ) and preferred C ( TWO.PC ).

The Arbitrage

Two Harbors is a levered mREIT that is active in agency issues and mortgage servicing rights. The company's equity capitalization is summarized in this table from Portfolio Income Solutions .

We have never really gone big into mREITs, but TWO preferreds caught our attention when they cratered in the illiquid market carnage of the early 2020 COVID outbreak. At that time we liked TWO.PC's 20+% discount to par and its double digit dividend yield. In the spring of 2022 we came to appreciate the preferreds' fixed-to-floating structure as some defense in a world where Central Banks might raise interest rates sky high.

In selecting among an issuer's preferred offerings you would first compare their coupons and yield at market price and also the relative upside to call. In the case of TWO's fixed-to-floating structure you want to consider both the calendar of each issue's call/conversion date and how many basis points over LIBOR (soon to be SOFR) they will pay on conversion. TWO.PA, TWO.PB, and TWO.PC are from the same issuer, so the distinguishing factors to rank their investment appeal are market price, yield at cost, discount to par, and calendar of call/conversion.

Markets are believed to be, ultimately, efficient; ultimately is the qualifying term of that statement because it accommodates the dislocation and deviation we see in today's trading of the TWO preferreds. The table above describes that TWO.PA has the highest face coupon and the highest premium pay rate over LIBOR on conversion, followed by successively, slightly lower numbers for TWO.PB and TWO.PC, respectively. If coupon and yield are the defining factors of market price, TWO.PA should carry the highest price, followed by TWO.PB, with TWO.PC priced the lowest. In recent weeks the shares deviated from this ordering and presented the arbitrage opportunity we describe here.

Optimizing Yield and Cost

As we stated earlier, price dislocations between related issues are quite common, but are usually fleeting or can't be exploited on significant scale. Back in February we noticed that the pricing of TWO.PC and TWO.PB had inverted and the inversion was sustaining and of sufficient volume to cause us to act. It looked like a chance to improve our yield, reduce cost, and enhance capital appreciation potential. This is what we saw.

Start

We owned a pretty significant position in TWO.PC purchased in 2020. The shares pay an annual dividend of $1.8125 to produce a yield of ~8.50% at a market prices hovering around $21.30. While still a thinly traded issue, the daily volume was more than enough to let us liquidate without negatively affecting share prices.

We simultaneously observed that TWO.PB, TWO.PC's sister share, was trading similar volume at prices ~1.5% lower. A 1.5% price improvement isn't something to get really excited about until you consider that TWO.PB pays an annual dividend of $1.90625/share which translates to a 9.08% at market prices hovering around $21.00.

The Net

We had vetted Two Harbor's operations, management, and capitalization back in 2020 and made the investment. We continue to monitor these things and in considering a trade we wanted to see if a swap could improve the terms and returns on our investment.

If an investor sold her C shares at $21.30 and reinvested proceeds into the purchase of B shares at $21.05, she would improve her carrying yield by more than 50 basis points.

She would also improve her portfolio's annual dividend income by more than 5%.

She could also improve the potential capital appreciation upside to call by $0.25/share or +1.17% against invested capital.

And, she could improve her portfolio's diversification because swapping the shares netted $0.25/share that can be reinvested elsewhere for additional returns.

We found these results compelling and swapped the shares.

Tools for Successful Arbitrage

Portfolio Income Solutions has created a continuously updated Fixed to Floating Preferreds array to spot such pricing dislocations. We also maintain a dynamic, ever changing, Arbitrage Tracker to help us spot trading opportunities in Merger & Acquisition transactions. As I said, these market pricing dislocations have become increasingly commonplace today.

I have been trying to gain investment advantage in this manner for more than 30 years and have learned that if you want to trade an arbitrage opportunity, success may evade you if you are not disciplined in the trading execution.

The Three Ps

Presence - After identifying an opportunity, you can't simply just place an order and hope for the best. You have to set alerts and be responsive to movements in spreads that market dynamics will present.

Persistence - If your order doesn't get filled, come back the next day and try again. Our experience is that we have often to wait days after the selling was done to get our purchases filled.

Patience - Don't become impatient when you are not getting filled and change or diminish your targeted parameters or spreads. If the spread widens you can go bigger; if the spread narrows, wait to play another day.

The markets are dynamic. Watchful, informed, active traders can sometimes seize alpha.

Happy Trading!

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