An 18% Yield Makes Two Harbors Investment Corp (TWO) the Best Buy

Two Harbors Investment Corp (NYSE:TWO) commenced operations in 2009 and seeks to invest in residential mortgage-backed securities, residential loans, residential real properties and other financial assets. The company’s target portfolio includes Agency RMBS and Non-Agency RMBS, therefore TWO is classified as a hybrid mortgage REIT. The stock is currently offering an elevated dividend yield of 17.7% and is trading at 38% premium to its book value.

4Q Performance Review

Two Harbors reported its performance for the fourth quarter of 2012 with better than expected book value and lower asset drag on core bottom line. The company reported a bottom line of $0.28 per share, missing estimate by $0.05.

Interest income of $137 million surged 85% year over year, while the net interest spread was 2.9% for the quarter, 20 bps lower than last quarter.

Investment Portfolio

During the most recent quarter TWO reduced its Agency MBS allocation by 4% to 53%, with the bulk of the equity going to residential rentals. With the successful completion of the Silver Bay IPO, this capital will be distributed to shareholders as early as the first quarter of the current year. At Silver Bay’s current price, this will be a $1.24/share distribution.

TWO repositioned the Agency portfolio to reduce prepayment and pay-up risk, and I expect future investments to have a bias towards credit given continued improvement in underlying fundamentals. Along these lines TWO completed a non-Agency securitization last week, where it retained the credit tranches. As Two Harbors Investment sold some RMBS assets, its MBS portfolio decreased by $1.3 billion. The portfolio will grow as TWO deploys the $821 million in un-invested cash at year-end. The end-of-period MBS portfolio was $1.8 billion.

Leverage

Two Harbors employed 3.4 times leverage on the MBS portfolio (excluding the Treasuries) at the end of the fourth quarter, down 0.5x from the linked quarter. As of the end of the recent quarter, TWO had 100% of its repo hedged with swaps and swaptions coverage of an additional 39%; this compares to 86% and 37% coverage last quarter.

Competition

Since Two Harbors is a hybrid mortgage REIT, MFA Financial, Inc. (NYSE:MFA), AG Mortgage Investment Trust and American Capital Mortgage Investment Crp (NASDAQ:MTGE) are its competitors.

MFA Financial has been in business since 1998 and seeks to invest in both Agency and Non-Agency MBS. Around 60% of the company’s asset portfolio is invested in Agency MBS, while the rest is non-Agency. Most of the non-Agency MBS are purchased at discounts to their par values and are considered very high quality. Within the Agency MBS, the company has a large concentration in 15-year fixed rate securities, which increases the prepayment protection, however a majority of it is not eligible for HARP. The company reported CPR of 21.6% for the third quarter, up from 20.4% at the end of the second quarter. MFA is currently yielding 8.8% and is trading at 29% premium to its book value.