Excellent Investment Opportunities In Two Harbors Investment Corp.

Two Harbors Investment Corp.

Two Harbors Investment Corp. is a mortgage REIT (mREIT) that is internally managed. The agency mREITs are only allowed to purchase mortgages that have been guaranteed by the government, thereby removing any credit risk. TWO owns a large amount of mortgage servicing rights. You can see this in their asset list.

MSRs are expected to be stable both in the present and the future, as the primary risk they face is prepayments of mortgages. Most people have mortgages that are below the current mortgage rate, so they don’t want to refinance. People are also unlikely to lose their mortgages unless forced to do so. There will always be exceptions.

TWO, like other mREITs has a low credit risk. However, it does have an interest rate risk. Their business model with mortgages is to borrow money on short terms and then use it to purchase mortgages that are usually higher yielding. In order to boost returns, they also use significant leverage. It’s fine when the short-term rates are lower than the long-term rates. But with our inverted yield curve, agency mREITs are in serious trouble. Over the past two years, 7 agency mREITs’ shares have dropped between 35 and 71%.

Two Harbors Common Stock

Currently, there are 7 of what I call agency mREITs. However, before COVID some of them were hybrids and not pure agency REITs. They changed their business model after the COVID crash, and now Cherry Hill ( CHMI), TWO have MSR investments. The chart below shows the performance of 7 mREITs in the three years after they became all agency mREITs.

You can see that TWO is in the middle in terms of performance in stock prices, with DX at the top and IVR, a really poor performer, in the back. What is most interesting is that TWO is selling at a massive discount to AGNC.

TWO is selling at a discount of 25.25% to AGNC. AGNC trades at 5.95% premium to TWO’s NAV, while TWO has a discount of 19.30%. As it does not matter to my thesis, I haven’t done any research on this. If TWO were trading at NAV or a premium, TWO’s performance over the past 3 years would be similar to AGNC’s.

TWO cut its dividend recently, which caused the stock to drop. Yield chasers fled when the dividend cut did not affect the value of the business. My personal preference would be to go long TWO, and short ARR. TWO outperformed ARR in the past 3 years and would have been even better if TWO had traded at the same discounted NAV price as ARR. It would make no sense to trade ARR at only a 2.39 % discount to the book value, while TWO would be trading at a 19.3 % discount.

It is important to note that I am not an expert on mREITs, and I do not know how TWO is hedging against ARR. However, it seems that TWO could outperform ARR’s 100% investment in its borrowing short and loaning long model. This looks to be deteriorating. The book values in the chart are from the end the first quarter, as I do not have access to the real-time book values of these agency mREITs.

You want to buy the same amount of TWO shares as you do ARR. Not the same number.

Two Harbor’s bargain Preferred Stocks

TWO offers 3 preferred shares: TWO A (TWO.PA), TWO B (TWO.PB), TWO C (TWO.PC). All three are LIBOR fixed to floating rate preferred stocks. All 3 are cumulative, and they qualify as Section 199A preferred stock which allows Americans to enjoy tax-free dividends on up to 20% of their dividends.

The chart below shows how the TWO preferred shares compare to other agency MREIT preferred stock.

The top four (plus the fixed-rate ARR), are separated, because they won’t be callable until 2027. If they aren’t called, they will not float before sometime in 2027. Let’s look at those first.

2027 Floaters

TWO.PB, as you can see, has the highest current yield amongst all agency mREIT prefer stocks yet to float. TWO-B’s 14.19% yield, if it floated today at current interest rates, would be the best yielder of the sector. It also beats out all other preferred stocks already floating, like NLY F, NLY G and AGNCN. As you can see from the table, TWO-B offers superior yields to the AGNC and NLY prefer stocks, both now and in the future. Later, I will explain why I think TWO preferreds are currently undervalued compared to AGNC or NLY preferred stocks. Even though IVR.PC is the worst performing agency REIT, TWO.B is still superior. This is illogical to me, and shows clearly that TWO B is undervalued in comparison with IVR C.

In the rightmost column, I have estimated where interest rates are likely to settle in 1.5 to 2.5 years. I believe that LIBOR is more likely to be around 3.5%, and the 5-year T-note will be closer to 3.75%. Others may have different opinions about future rates.

Even in a low rate environment, TWO-B will still yield 11.55%. This will look great in a low rate environment. I expect its price to rise significantly in the future.

The TWO-B fixed-rate preferred stock is better than the ARR.PC, because it has a higher current yield. Comparing TWO-B to the fixed-rate preferred ARR.PC of agency mREIT, it is a far superior stock with a current yield of 9.95% versus 8.37% for ARR.PA. It is highly recommended to switch from ARR.PC over to TWO.B.

The Agency Preferred Stocks that Float within 1 to 1.5 years

If you’re looking for a mREIT preferential stock that is likely to float in 1 to 1,5 years, then TWO.PC offers the best metrics: the highest current yield, the highest floating yield, and the largest discount from par, giving it the greatest capital gain potential. I believe that TWO-C has a much higher value than AGNCO or NLY-I because people discount TWO preferreds unfairly.

TWO C is $3.98 cheaper than NLY I, even though they both have the same floating rate formula. The difference increases if you take into account that TWO C will soon be ex-dividend. TWO-C, which will continue to pay a 9.46% yield until NLY-I is floated, will also be paying a higher yield than NLY-I. NLY-I will float 7 months earlier than TWO C, so it will pay a higher rate for those 7 months. However, this does not compensate for the huge difference in price and yield. TWO-C, at least to my mind is undervalued compared to NLYI. It also has a much higher price potential and a large yield advantage.

It is important to note that AGNCN is already floating and is currently priced at $25.45. The formula for its floating rate is not much different than that of TWO C. If short rates continue to be high, TWO-C could move from $19.45 up to $24.00 within 1.5 years. This would still make it undervalued compared to AGNCN. I expect TWO-C to never trade at the exact same price as AGNCN because of discrimination against smaller cap REITs. However, the gain will be substantial.

Even though IVR-B is a small-cap mREIT (as opposed to TWO-C), it’s a better value.

TWO Preferred stock safety (Not much different than AGNC &NLY Preferreds).

The chart above shows that the yields on TWO preferred stocks are higher than the yields on the preferred stocks of AGNC and NLY. Is this really justified? I don’t think so. I’ve always performed better than AGNC and NLY by investing in smaller names, like TWO and CHMI preferred stock.

TWO preferreds have the same leverage as AGNC or NLY preferreds, which is why I think they are almost as secure. The fact that TWO’s last quarter was bad didn’t really matter because they had sold 10,000,000 shares and their leverage at the end was lower than it started the quarter. The preferred stock has not been damaged.

These agency mREITs, in particular, are issuing common stock to maintain their leverage at normal levels, particularly when NAVs continue to fall. NLY also has issued common stock on several occasions. As long as the companies intend to issue common stocks to raise cash in order to cover losses, it doesn’t really matter which one you buy. TWO is better protected from the current yield curve inversion than other mREITs because of its large investment in MSRs. This yield curve inversion could well be exacerbated over the short-term, as the Fed is likely to raise short-term rates.

Summary

First, we discussed a pair-trade: buying TWO common stocks and selling ARR common stocks. TWO, despite having outperformed ARE in the last three years since they both became pure agent mREITs (most recently), trades at a 19.30% discount to book value compared to only a 2.39% for ARR. This gap will close as I do not see any reason for it. We can also profit by their discounts becoming closer. If you are interested in trading this pair, then go long the exact same amount of TWO that you shorted ARR.

We then discussed the agency mREIT prefer stocks, which will either be called or float by 2027. TWO-B has the highest yield, a stripped yield of 9.5%, and a floating yield using current LIBOR at 14.19%. If LIBOR falls from its current level of 5.53% to 3.50%, then it will have a floating yield of 11.55%. The most attractive part is that it trades at a discount to par, giving the greatest potential for capital gains. If short rates drop from here, call protection is available until 2027. This means you can continue to earn your 9.95% for four more years. TWO-B, which is a fixed rate preferred, looks better than fixed rate mREIT preferred ARR-C, which only yields 8.37%. I think a swap from ARR C to TWO B is a good idea, as you get 1.6 % more yield.

We then discussed the preferred agency mREITs that will be floating in the next one to 1.5 years. TWO-C is the best performer in this category. It has the highest yields, both current and floating, as well as a price increase. TWO-C’s price should rise dramatically as the floating rate date approaches in 1.5 years, whether LIBOR stays where it is, increases, or drops slightly. In my opinion, TWO-C’s value is $2.50 less than NLY-I. I strongly recommend switching from NLYI or AGNCO to two-c.

TWO preferreds offer a much higher yield than NLY, AGNC and even IVR preferred stocks – IVR is a small company (TWO being 2.5 times bigger than IVR). This further documents the undervaluation TWO preferred stock.

Lastly, I said that even though the yields of TWO prefers are higher than those of AGNC or NLY preferreds, there is not much difference in terms safety. Therefore TWO prefers are undervalued. TWO is at the same level of leverage as AGNC and NLY, and all mREIT preferential issues have been releasing stock to stay around this leverage level. Even when TWO experiences a bad quarter they still sell enough common shares to prevent leverage levels from increasing. The company issued 10,000,000 common shares last quarter. The survival of Agency mREITs is paramount. As long as all are doing the necessary things to make sure they survive, including paying their preferred stock dividends, then why not purchase the undervalued one based on its yield? TWO preferreds not only have higher yields than NLY or AGNC, but they also offer greater potential for capital gains at prices that are lower.

• Note: 20% of TWO preferred shares dividends are free from tax. TWO preferred stocks will be ex-dividend on July 11 .