Two Harbors (TWO): Drop Anchor On The Series C Preferred

Investment Thesis

The Fed continues to raise rates. It appears the pace is slowing, with most economists forecasting a 50 basis point rise in December and anywhere from 25 to 125 more in basis point rises in 2023. We are predicting a total of 100 basis points, with 50 in December and 50 more in 2023 before the Fed pauses to assess how core inflation is falling.

If Two Harbors Investment Corp. (NYSE:TWO) management continues to steer as prudently as they have so far in 2022, we forecast the preferred stocks will tether to par as their conversion dates pass unless something truly strange happens in the credit markets (very unlikely).

It all starts with managing TWO’s leverage and overall equity cushion. From their 2022 Q3 Earning Call:

“As mortgages cheapened, and as book value declined in September, we allowed our economic debt-to-equity ratio to drift higher, from 6.4 to 7.5 times. In October, being respectful of market volatility, we thought it prudent to somewhat reduce our leverage. We sold RMBS and used some of the proceeds to repurchase 2.9 million shares of preferred stock at a deep discount to par. At the end of October, our debt to-equity ratio was right around 7x.”

TWO had previously announced its intention to repurchase up to 5MM shares, so they got about 60% there. Why did they stop when prices were around 60% of par? We think leverage was getting too high and more equity was deemed prudent before purchasing more. The 1:4 reverse stock split earlier this month and the 8-K filed on 11/10/22 make it clear a secondary equity offering is coming.

Reverse splits during downward cycles for book values typically signal a real estate investment trust’s (“REIT”) intention to fix its leverage ratio by adding more equity to the financing stack. As an Agency REIT, investors are out there. We believe TWO management is just waiting for the right day to price relative to their estimated book value (or NAV).

When more equity is underneath, TWO preferreds will be amply supported. Currently, the equity under the preferreds is about 1.8 times, which we view as thin. They also have cash flow coverage on all preferred dividends at about 7.5 times, which is quite comfy.

Under The Hood

Two Harbors holds, hedges, trades and buys forward Agency mortgage-backed securities as issued from time to time by Freddie Mac, Fannie Mae, and Ginnie Mae. Those securities are considered to be equivalent to U.S. Government risk based on past actions during mortgage crises like the GFC in 2008, or roughly AA+. TWO also own mortgage servicing rights, which have high value when mortgage repayments slow down.

These are very high-quality assets.

How TWO finances these is critical to understanding where relative values and risks lie relative to realizing value from the common and preferred stocks.

Two Harbors is quite traditional in its approach, using short-term repurchase agreements hedged by a variety of derivatives and TBAs (forward purchases of Agency Mortgages).

During the great book value reduction of 2022 for mortgage REITs, no hedging completely offsets mortgage asset value declines (arbitrages like that would be quickly wiped out). They do produce, however, scads of distributable income to partially offset those asset value declines.

Predictably, as interest rates have rocketed higher, TWO has reported overall losses entirely due to declining asset values swamping all that extra cash flow.

The biggest risk to a REIT like TWO is not defaults (defaults would be cured by the government agency issuing the security), but rather the inability to issue more equity if book values continue to decline. We note that during the GFC, Agency assets were equity-financed.

AGNC Investment Corp. (AGNC), the second-largest Agency REIT by market cap today, was started during the GFC, and TWO went public during the tail end of the GFC in 2009. There is an appetite for this equity risk as long as the REIT managers are respected, and TWO’s are.

As an internally managed REIT, TWO avoids potential conflicts of interest that can exist when there are external managers whose allegiance is to a larger set of considerations. Additionally, TWO senior management is well-seasoned, in our opinion, in mortgage risk.

Current Strategy

From TWO’s Q3 earnings call:

“With the duration of the 5% coupon being only 60% of the duration of the 2% coupon, we see the value of higher coupons to be even greater when the spreads are expressed per unit of risk or duration.”

Management is targeting those higher coupon mortgages for greater current returns, less duration volatility, and for the wider credit spreads they note exist for these coupons. Their strategy with respect to mortgage servicing rights is the opposite. Why the difference?

Mortgage servicing rights purchased by TWO this year were based on value assumptions that mortgage prepayments would be much slower. They are far slower in the 2% coupon mortgage securities than high coupon mortgages because who wants to admit they traded in a super cheap mortgage unless it was for a compelling reason (job, change in family, etc.)

The biggest risk we see here is capping the upside on Agency par value recovery. Those 2% mortgages currently trade at the deepest discount, which creates a nice capital gain upside when the mortgage is repaid. Building in the capital gain recapture, of course, reduces the interest margin a holder can receive today.

We see TWO going for performance today over performance tomorrow and that makes reasonable sense. It also negatively impacts upside for the common equity while offering big positives for the preferreds.

Common Equity Valuation

Mortgage REITs, like most financial entities that buy and hold securities, are valued on their current net asset, or book, value. As of September 30, 2022, TWO placed its net asset value at $16.42 per common share. At $16.10 on November 21, 2022, TWO trades at less than a 2% discount. That’s fairly valued to even rich considering TWO has signaled a secondary equity offering.

Let’s compare TWO to other Agency REITs: AGNC, Annaly Capital (NLY), Cherry Hill Mortgage (CHMI), Dynex Capital (DX), and Invesco Mortgage (IVR). All of them have reported 2022 Q3 results within the past 60 days. While actual NAV has moved, these numbers are still relatively fresh:

Ticker	Q3 Book Value	11/21/22 Share Price	Prem/(Disc) to Book
TWO	$16.42	$16.10	(1.95%)
AGNC	10.14	9.49	(6.41)
NLY	19.94	20.52	2.91
CHMI	6.25	5.94	(4.96)
DX	14.31	12.51	(12.58)
IVR	13.08	13.15	0.54
Average			(3.74)

Click to enlarge

Source: SA and my calculations.

Two is fairly valued today and if they can price a secondary at a premium to NAV, we will benefit from a new cushion under the preferred stocks.

Is the TWO common investable today? We think “not yet.” We see the case, though, for holding an existing investment with the understanding further book value destruction is coming. TWO’s current strategy to minimize future capital gains for more income today is better for the preferreds. When rates top out, we will reevaluate.

Two Harbors Preferred Stocks

There are three sets of preferred currently trading summarized below:

Preferred	Annual Dividend	Call Date	FtF* Date	FtF Margin over LIBOR**	Current Price	Current Yield	Yield to Call
TWO.PA	2.03125	4/27/27	4/27/27	5.660%	$19.30	10.52%	15.07%
TWO.PB	1.90624	7/27/27	7/27/27	5.352	18.20	10.47	15.65
NYSE:TWO.PC	1.8125	1/27/25	1/27/25	5.011	17.975	10.08	23.80

Click to enlarge

Source: SA, Quantum Online, and my calculations.

*Fixed-to-Floating

**LIBOR is going away in June 2023 to be replaced by 3-month Term SOFR plus 26.2 basis points as administered by the CME. Currently, and mostly due to UK financial volatility, LIBOR is currently 38 basis points higher, or 12 basis points higher than the SOFR replacement rate.

Here we see the Series C preferred offers the lowest dividend, smallest current yield and the best Yield to Call. Why? Time.

It’s going to take the Series A & B more than 2 years to tether toward par. That could be an amazing investment if rates fall quickly in the next couple of years, degrading the Series C returns after it floats, but we do not see that case as at all likely.

More likely is that this interest rate cycle, given the stickiness in core inflation, will float down slowly from peak rates over a number of years, making the Series C our choice to buy today (we more than doubled our position 11/22/22 at $18 per share).

Conclusions

While Two Harbors common stock trades very near its Q3 2022 net asset value, we see headwinds where we see tailwinds for the three preferred stocks, and especially for the Series C (TWO.PC), which is our recommended buy today.