TWO - Two Harbors: The Dividend Is Still In Jeopardy

Summary

• The Two Harbors Investment Corp. dividend was recently cut.
• Two Harbors' Q4 showed some stabilization in rates, a tightening spread, better book value, but horrible earnings that did not cover the dividend.
• If the company misses badly again on earnings for distribution, do not be surprised if the dividend is cut again.

Two Harbors Investment Corp. ( TWO ) stock has been a tough investment as it operates as a mortgage real estate investment trust, or mREIT. The volatility in interest rates has weighed, and the pressure on the company in trading mortgage-backed securities and related instruments has intensified. Thankfully, TWO stock is well off its 2022 lows, but pressure remains.

The interest rate spreads have widened so much that it has become a problem, and the inverted yield curve has been a problem. The fact is that with the volatility, companies like this that buy and sell mortgage securities have certainly struggled. However, the climate does seem to be improving somewhat. While the Federal Reserve has been unwinding its balance sheet to some degree, or at least, reducing it, the pace of interest rate hikes has slowed.

We do believe rates will be more stable in 2023, which should help this sector. While prepayment risk has declined as refinancing is simply a poor option for many due to higher rates, spreads were all over the map in 2022 and book values were pressured once again for many in the sector. However, Two Harbors' Q4 saw some signs of improvement, but the just-reported Q4 earnings suggest another dividend cut is quite possible. We predicted a dividend cut was very possible in Q3.

Some stabilization in Q4

Make no mistake, the Agency RMBS market is still tough right now as rates continue to be volatile, although for the most part mortgage servicing rights, or MSRs, are holding up. Investing in both types of instruments has been a decent plan for the company portfolio, at least as best it can with the movement in the rates. Spreads tightened and that helped book value. 2022 was one of the most challenging years for this sector in decades. In Q4, we saw that inflation moderated and rate expectations leveled off, but volatility remained pretty high, yet Two Harbors saw a benefit from low coupon MSR and higher coupon Agency RMBS.

Comprehensive income swung back to a gain of $160 million, as compared to the losses of $287 million in Q3 and losses of $90.4 million in Q2. This came as the company levered up in November but then levered down some in December. Total debt-to-equity narrowed to 4.4X from 5.5X in Q3, helped in part thanks to increases in book value and gains in the portfolio's holdings. Net interest income slipped negative to 16.3 million in losses from $12.8 million in gains a year ago. Overall pretty mixed, but Two Harbors investors here care about the dividend.

Dividend was not covered

Net interest income has been weak all year, and in the quarter it was negative. While the portfolio is stabilizing, and book value recovered, we measure the dividend safety by comparing the payout to the earnings available for distribution. The sector has moved to reporting distributable income, which is now reported in place of core earnings. That said, we were looking for $0.60, which would be just enough to cover the dividend. This $0.60 in dividend payouts was down from $0.68 following the 12% cut. Another cut is more than possible because distributable earnings came in at $22.2 million, or just $0.26 per share. We should have known it would have been a weak Q4 given Two Harbors cut in December. At the new rate, Two Harbors stock pays an annualized yield of 15.7%.

The spread narrowed from Q3

We have had yield curve inversion and extremely volatile rates. The narrowing of the spread helped book value but, of course, impacts income potential.

The annualized yield on the company's portfolio assets was 4.92%, up 31 basis points from the sequential quarter. The annualized cost of financing widened by 111 basis points in Q4 to 3.95%. Because the yields did not rise as much as the costs to acquire those funds rose, the net interest rate spread narrowed from Q3. This is a reason net interest income fell to a loss. The net interest rate spread fell from 1.77% to 0.97%.

Constant prepayment rates

Given high rates, many borrowers are not refinancing, and as such, we are not seeing as many prepayments. Still, the CPR is somewhat more elevated than we would like. But they have come down tremendously. In Q4, we saw a 5.9% CPR for the Agency RMBS, down from 9.2% for the Agency RMBS in the company portfolio in Q3, and down from Q2's 14.2%. It fell all year, due to rates going up. That is one positive from all of this.

Book value increased

The Two Harbors dividend was not covered. Another metric we focus on for an mREIT stock is book value. When we are ready to buy in this sector, we prefer to purchase when the stock is at a discount to book value. There were big declines in Two Harbors' book value all year as the portfolio value was crushed. Book was reported at $17.72 compared to $16.42 at the end of the third quarter. The tightening of spreads impacted the book value. We think we see real stabilization in book value in 2023 because rates should be less volatile. Shares are currently at $1.00 or 5.6% discount to book.

Final thoughts

The Two Harbors Investment Corp. dividend was cut thanks to underperformance. The earnings for distribution this quarter were just rough. The newly cut dividend was not even close to covered.

So far, Q1 looks like rates have picked up in volatility, dropping in January and rising in February. This may impact the Two Harbors portfolio again. If Two Harbors Investment Corp. misses badly again on earnings for distribution, do not be surprised if the dividend is cut again.

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