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Two Harbors Investment (NYSE:TWO) has struggled. The company is in a tough sector, as a mortgage real estate investment, or mREIT. Rates rising have wreaked havoc on mortgage backed securities and related instruments. Make no mistake, this company experienced a lot of pain during COVID and really never fully got out of the pain, though things were looking good in late 2021. Then here in 2022, the entire macro situation worsened quickly. As an mREIT, the action the Federal Reserve has taken the last few months has weighed heavily on operations. Most stocks in this sector got beaten down hard in the spring, and only started rebounding. The Federal Reserve’s very aggressive response to high inflation weighed on real estate hard in Q2, and companies like this that buy and sell mortgages and bundles of mortgages got taken to the woodshed. It just is tough when the Federal Reserve twice increased its target rate for the federal funds rate, including a 75 basis point hike in June. And the Federal Reserve is also running off its balance sheet, selling its holdings in treasuries and mortgage backed securities, or MBS balance sheet items. With Two Harbors the portfolio holdings and of course book value have struggled of late with the volatility in rates. In this column, we discuss the recent performance and more importantly where we see things going.
Q2 earnings overall decent
The company has been recovering since the pandemic lows, but has taken it on the chin for the last four months with the rate hikes, mortgage rates moving, housing demand changing, and the volatility associated with it. That said, the company did have a quarter that had a couple strengths to be aware of.
Right now the Agency RMBS market is tough but mortgage servicing rights, or MSRs, have performed somewhat well. Pairing them both has worked decently for the company, at least as best it can with the movement in the rates. Spreads have widened to strong levels and the company expanded its portfolio during the quarter.
Comprehensive losses were $90.4 million in the quarter. Ouch. But they expanded their debt-to-equity from 5.3X to 6.4X to take advantage of the strong swings in hopes to move into positive earnings. Net interest income was $19.9 million which was good, and more importantly the dividend was covered.
Dividend was covered
While net interest income may seem weak it was up from Q2 2021 by 2%. Further, the best gauge for dividend coverage remains in our opinion, core earnings. The sector has moved to reporting distributable income which is now reported in place of core earnings. That said, we were looking for $0.18, which would be just enough to cover the dividend. Well, distributable earnings came in at $75.3 million or $0.22 per share, which also exceeded consensus expectations by $0.03.
This was actually better than we expected on our end as well by $0.04. The key here is the dividend was covered. The company paid $0.17 per share and this is positive, considering the annualized yield is a wild 13.5%.
The spread is widening and that is bullish
The net interest rate spread is a critical indicator. You want to have a sense of these figures and the way it is trending it because it serves as a gauge for potential earnings power of an mREIT. To calculate the net interest rate spread, the calculation is quite simple. We calculate it by takin the difference of the yield on assets, and the cost to acquire those assets. The higher this indicator, the better. Let us take a look at the numbers, and calculate the spread.
The annualized yield on the company’s portfolio assets was 4.39%, up 89 basis points from the sequential quarter. We also saw a pretty sizable increase in the annualized cost of funds from 0.70% in Q1 to 1.13% here in Q2 2022.
Because the yields increased more than the costs to acquire those funds, we saw a widening in the net interest rate spread. If we take the difference of these two variables, it results in a net interest rate spread that widened from 2.75% in Q1 to 3.26%. Winning. Movement in interest rates have impacted the spread, and the spread impacted income largely and will continue to do so.
Constant prepayment rates
Overall high levels of mortgage prepayments are always problematic in the mREIT sector. Obviously the rates of prepayment will vary company to company depending on the type of holdings. Essentially prepayments mean less interest income when they are made. As you can imagine, borrowers are not rushing here to refinance with mortgage rates so much higher than they have been. The constant prepayment rates dipped from Q1. They were a reasonable 14.2% for the Agency RMBS in the company portfolio. This was down from 17.3% in Q1, and much lower than a year ago. There are many reasons for prepayments, but usually consumers want to sell and refinance at better rates, or prepay before rates rise. Here we are not seeing either of that, and that is bullish as we move to H2 2022.
Book value
Obviously dividend coverage is critical when we buy an mREIT stock. Another metric we focus on for mREIT stock is that we like to purchase when the stock is at a discount-to-book value. Book value drives the share price of mREITs in conjunction with the dividends, and of course, momentum in the sector. Book was reported at $5.10 at the end of the quarter. It was down because of the huge changes in spreads and valuation changes to the port. With the current spreads, the company has started expanding its holdings and we believe book value starts to improve as we move toward 2023. However, at $5.05 per share, there is not much of a discount here. We would like the shares to fall back under $5 before buying.
Final thoughts
We want to make sure the dividend is covered, which it was, and nicely. The spreads in the sector are attractive, and we think this is going to be a good period for mREITS once the hiking cycle is complete later this year.
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