Four Reasons to Buy This 18% Dividend Yielder: Two Harbors Investment Corp (TWO) and More

Two Harbors Investment Corp (NYSE:TWO) has operated as a mortgage REIT since 2009 and primarily manages residential mortgage backed securities, residential mortgage loans, residential real properties and other financial assets. The company is externally managed by PRCM Advisors LLC, a wholly-owned subsidiary of Pine River.

Business Diversification

Two Harbors’ investment portfolio as of Dec. 31, 2012 is very well diversified, giving the company an edge over American Capital Agency Corp. (NASDAQ:AGNC), Annaly Capital Management, Inc. (NYSE:NLY), ARMOUR Residential REIT, Inc. (NYSE:ARR) and MFA Financial, Inc. (NYSE:MFA).

Figure 1 above shows the proportion of Agency residential mortgage backed securities to non-Agency RMBS in the company’s entire assets portfolio. It is evident from the graph above, Two Harbors has a large amounts of Agency RMBS in its portfolio, while high yielding non-Agency RMBS form 19% of the portfolio. At the end of the fourth quarter, the company’s Agency MBS yielded 2.9%. In contrast, its non-Agency MBS yielded 9.5%. A closer look at the types of securities held by the company reveals fixed rate securities constitute 80%, while 20% of the entire asset portfolio is adjustable-rate securities.

While Two Harbors primarily operates as a mortgage REIT, it has initiated acquiring residential real properties across the United States. It has plans to hold these properties for future investments and rent them out for income like an equity REIT.

Therefore, Two Harbors provides its investors complete diversification within the REITs sector of the United States.

Key Financials

During the most recent quarter, the company earned 2.9% net interest rate spread. This is compared to the 3.1% spread earned during the linked quarter of 2012. This is the spread between what Two Harbors earned on its interest yielding assets and what it paid on its interest bearing liabilities.

At the end of the fourth quarter, Two brought down its debt-to-equity ratio to 3.4 times, against 3.8 times at the end of the third quarter. Keeping lower levels of leverage in such challenging times is advisable.

During the quarter, Two Harbors used interest rate swaps with a notional principal of $19 billion, of which $17.5 billion was utilized to economically hedge interest rate risk associated with the company’s short-term LIBOR-based repurchase agreements.

During the fourth quarter, the prepayment speed for Two’s Agency MBS holdings was 6.6%, while it was 3.2% for its non-Agency MBS holdings. Since the Agency MBS are purchased at a premium to their par values, they experience much higher prepayment speeds, compared to non-Agency MBS, in the event of decreasing interest rates.

Dividends

The company announced $0.55 per share as quarterly dividend for the fourth quarter of 2012. Since it was the last dividend of the year, it was intended to distribute the remaining REIT taxable income earned during 2012, including the taxable income earned from Silver Bay Property Trust. This is compared to $0.36 per share dividend for the third quarter of 2012.

Going forward, I believe investors should not expect a “significant” decline in the quarterly dividends of Two Harbors. This is, say, after looking at the upward trend in the mortgage rates in the US. Rates have continued their upwards journey since the beginning of the year, and I believe this will help support the company’s net interest spread and dividend distribution.