2023-05-11 07:24:42 ET
Summary
- TWO is a REIT focused on the residential and commercial mortgage-backed securities markets.
- The company has some attractive investment potentials, which are long term in scope.
- Despite the attractive investment potential, the strong headwinds and risks limit immediate entry and warrant a hold rating for the business to realign and the headwinds to subsidize.
Investment Thesis
Two Harbors Investment Corp. ( TWO ) is a real estate investment trust [REIT] focused on the residential and commercial mortgage-backed securities markets. The company mainly invests in residential mortgage loans, collateralized mortgage obligations [CMOs], and agency and non-agency residential mortgage-backed securities [RMBS]. Its portfolio is run by its affiliate, PRCM Advisers LLC.
The company, in my perspective, is set up quite effectively for the present market environment. It is an appealing investment prospect for those seeking exposure to the real estate market because of its diversified portfolio, but the headwinds and risks warrant a hold rating.
Why Invest Here?
Diversified Portfolio
When considering investing in TWO, looking more closely at its features is essential. The company has exposure to both single-family houses and apartment complexes. Diversification helps protect investors from volatile markets because the success of one sector doesn't directly affect the rest of the portfolio.
It also has a diversified portfolio that includes agency and non-agency RMBS , CMOs, and home mortgage loans. Mortgage-backed securities [RMBS] are divided into agency and non-agency. Agency RMBS are backed by mortgages guaranteed by government-sponsored entities (GSEs) like Fannie Mae and Freddie Mac. A collateralized mortgage obligation [CMO] is a mortgage-backed instrument that consists of a pool of individual mortgage-backed bonds. They are able to control their risk and limit their exposure to any single market segment by investing in a wide range of these securities.
Investment Strategy
TWO's investment strategy is focused on generating solid returns while managing risk. The company seeks to identify undervalued securities and opportunities for long-term growth while employing hedging strategies to mitigate risk. Its investment approach is grounded in rigorous analysis, disciplined risk management, and a long-term perspective.
Competitive Advantage
TWO's edge over its competitors is that it has a wide range of investments. By investing in a mix of agency and non-agency RMBS, CMOs, and residential mortgage loans, the company is able to control risk while also getting good returns. Also, the company's strategic use of hedging methods and disciplined approach to allocating capital has made it more competitive in the market.
Book Value and Dividend Situation
The company's book value has been declining since Q1 2022, and its dividend has also been volatile. In the MRQ, their book value on March 31 was $16.48 per share, representing a negative 3.6% total economic quarterly return. The management stated that the book value was impacted by the violent move lower in rates arising from the banking crisis. With the mayhem in the banking sector, this trend in its book value may persist, causing the company to lose its value.
TWO Q1 2023 Call Presentation
The dividend payout was recently cut from $0.68 per quarter to $0.60, but the stock's drop has increased the yield to above 19%. The dividend reduction should be over now. In the first quarter, there was just $0.09 in distributable earnings, so that wasn't even close to being enough to pay out.
While TWO may be able to pay for it, the company doesn't appear to have much wiggle room in its budget. Investors should be wary when dividend yields for mortgage REITs are in the high teens. However, the fact that the stock is trading at a 25% discount to book value per share suggests the market expects book value per share to continue falling, in my opinion. In my perspective, it requires aligning a lot of things to perform excellently ranging but not limited to dividend payout, and any new investors risk seeing the dividend reduced. As a result, two Harbors is a high-risk investment that most income investors should avoid.
Short-term Headwinds
This company is currently experiencing certain headwinds, which will, in my opinion, negatively affect its short-term success. First off is the increased volatility in interest rates. As interest rates increased throughout last year, the value of mortgage-backed securities declined. The Fed has yet to end one of the most aggressive rate-tightening cycles in history, and mortgage-backed securities are susceptible to interest rate volatility. In addition, higher-than-expected inflation figures in January and February drove up rates, only to have them quickly reverse with the failure of Silicon Valley Bank in March and the spreading contagion to other regional banks, leading to heightened volatility in the first quarter. If this volatility is to persist, then I expect this company to be affected significantly in the short run.
Another immediate challenge is the sale of mortgage-backed securities by banks. The mortgage market faced a new challenge due to the regional banking turmoil: increased supply. Mortgage-backed security demand has fallen as the Federal Deposit Insurance Corporation [FDIC] sells off insolvent banks' assets. The Federal Reserve, which was a major purchaser during the era of quantitative easing, is now a minor participant. The only remaining buyers are banks, bond funds, and mortgage REITs, and they are proceeding with caution.
The residential mortgage-backed securities [RMBS] portfolio will suffer as a result of this, while the mortgage servicing portfolio will benefit in the long run. On the plus side, rising mortgage rates directly result from bad mortgage pricing; therefore, refinancing is highly improbable under these circumstances. Mortgage servicing rights are vulnerable during periods of high refinancing activity. In the future, the firm expects the RMBS portfolio to bring in returns in the low to mid-teens.
Risks
Investing in TWO has a high degree of risk due to the company's reliance on the real estate market for growth. As a result, the company's ability to produce income from its properties is sensitive to the market's health.
Interest rate increases are another possible threat. TWO is a real estate investment trust; thus, it faces interest rate risk that could reduce its profitability.
Conclusion
I see a number of red flags with this company, including a volatile dividend and falling book value, despite having some promising investment potential. In light of the information in this article, I believe it's prudent to wait for the company to realign itself by stabilizing its dividend by delivering sustainable dividends. It also makes sense for potential investors to wait for the headwinds to subside before cashing in on this company.
For further details see:
Two Harbors Investment: Wait For Dividend And Book Value To Stabilize