In our January earnings review from Two Harbors Investment Corp. (NYSE:TWO) we rated it a Hold, despite the earnings leaving something to be desired. In Q4, interest rates stabilizing were seen as a benefit for the company, vs. rates that were falling and moving rapidly. The yield curve had been un-inverting, making mortgage real estate investment trust, or mREIT, operations more stable, in our view. In this column, we check back in on TWO, which just reported its Q1 earnings.
A higher for longer interest rate environment is a positive for Two Harbors Investment Corp.
While we have seen a rise in interest rates in 2024, given the company’s portfolio is focused primarily on mortgage servicing rights, or MSRs, higher for longer interest rates are seen as benefiting the company. Further, as interest rates are high, prepayment risk for the mREITs have continued to decline as refinancing volume is much lower in the mortgage space given new mortgages are at much higher rates than average. Spreads continued to be volatile, but that volatility has calmed down in the last few months. A rising rate environment was a positive for Two Harbors in Q1, and earnings were strong. Two Harbors’ President and CEO noted this in the press release:
“Our portfolio of MSR, which represents more than 60% of our capital allocation, is positioned to benefit in an environment where rates are higher for longer. Our portfolio’s prepayment sensitivity remains low, with less than 1% of loans having an economic incentive to refinance and over 85% of loans at least 250 basis points below current mortgage rates.
Thus, this gets at the point we made above regarding prepayment risk. Now, although the market remains subject to future periods of high realized rate volatility, what we saw in Q1 is that nominal spreads for Agency RMBS are pretty wide on a historical basis, so that means Two Harbors and others in the space can see attractive levered returns.
Q1 Earnings Reflect Strong Income Generation
Income was strong in Q1. Comprehensive income came in at a gain following gains in Q4. Back to back quarters of comprehensive income gains is quite positive. In Q1 Two Harbors reported comprehensive income of $89.4 million, or $0.85 per share. This was more than double the comprehensive income in the sequential quarter. Recognizing opportunity, management put a little more money to work, as evidenced by the leverage, as measured by total debt-to-equity ticking higher. Total debt-to-equity increased from 4.5X in Q4 2023 to 4.6X in Q1 2024. We mentioned favorable spreads above. However, the portfolio is still seeing interest expense outpace interest income. Net interest expense was $42 million. However, servicing income far outpaces servicing costs, and servicing income was $159.2 million. Other income was positive $146 million, and we saw a $47 million gain on derivative instruments. Factoring in expenses, we saw net income attributable to shareholders of $192 million, or $1.85 per share.
What about dividend coverage?
Two Harbors’ Dividend coverage
Obviously, when real net income is this positive, it’s safe to say the dividend was covered. The way these mREITs have reported their dividend coverage over the years has evolved. A bit of accounting sorcery, some may say. Two Harbors now uses earnings available for distribution. This is an adjusted measure which includes net interest income, accrual and settlement of interest on derivatives, dollar roll income on TBAs, U.S. Treasury futures income, servicing income, net of estimated amortization on MSR and certain cash related operating expenses. Management, however, notes that this figure:
“Is one of several measures our board of directors considers to determine the amount of dividends to declare on our common stock and should not be considered an indication of our taxable income or as a proxy for the amount of dividends we may declare.”
Thus, this makes it difficult to gauge whether the earnings power covers the dividend. The fact is, this metric does not capture hedging derivatives and weighted yield to maturity at purchase. Given real income, we view this as covered.
Book Value Increases
One of the other key metrics we look at besides interest rate spreads, servicing income, and the somewhat cryptic earnings available for distribution is book value. In Q1 book value expanded. Book value was reported at $15.64 compared to $15.21 at the start of the quarter. This was a $0.43 increase, or 2.8% increase on book value. This result lends evidence to our assertion in January that we would see “ongoing stabilization in book value in 2024″ because rates should be less volatile.” What’s more, the discount-to-book is now well over 10%, in fact, it’s closer to 20%. A 20% discount to book is historically a buy signal, and thus, we think this presents an opportunity for some upside. While a sub $12 price could have been had in the selloff earlier this month, this is a decent price to pay, all things considered.
Final thoughts, consider preferred shares
Like we saw in the last few quarters, interest expense is far outpacing interest income. However, MSRs and servicing income have been strong. There’s little prepayment risk on the books. And the spreads are starting to improve for RMBS. We think it will be hard to see significant tightening of RMBS spreads unless there’s a huge dovish pivot by the Federal Reserve at the policy meeting this month or next. Earnings for distribution were positive, but it’s tough to gauge dividend coverage here, even with comprehensive income so positive. That said, the operating environment being higher for longer plays into management’s approach in a positive way. The reduction in volatility in rates has helped, and higher rates are viewed positively. We continue to rate it neutral, but the discount-to-book is sizable. As noted in January, Two Harbors’ common stock offers a bountiful yield, but consider buying the preferred shares. It’s a much better way to play it than the commons in this space more often than not.