Credit Suisse in a report to its investors lowered the price target for Two Harbors Investment Corp (NYSE:TWO). This article will attempt to explore the reasons behind this decrease in the target price and also to see if it is a concern for you.
Price Target Lowered
Investment Mix
Within Two Harbors’ Agency holdings, returns are expected to improve as spreads widened during the first week. Credit Suisse expects to see 10 – 12% returns on its Agency MBS given the leverage remains within the range of 6 – 7 times. This means Credit Suisse is expecting an increase in leverage from its current level of 5.7 times. Agency spreads are dependent on the economy and the timing of the exit of the government’s easing. However, in the short-term, the management of Two Harbors is expecting tightening in Agency spreads.
Given the current macroeconomic environment, Two Harbors Investment Corp (NYSE:TWO) MSRs present an excellent opportunity. Two Harbors received Freddie Mac’s approval on March 14, while the approvals from Fannie Mae and Ginnie Mae are on their way. Now Two Harbors can operate as a mortgage servicer, which will further diversify the company’s investment portfolio. Two Harbors is expected to hire a sub-servicer, which will perform the servicing on any acquired MSR. The company is expected to announce acquisitions of MSRs during the second quarter of the current year, and looking at the rest of the servicers, you can expect to see a robust pipeline of MSR activity for the company.
MSRs are viewed as an attractive investment given the expected return would be around mid-teens on an unlevered basis. This is better than the other opportunities Two Harbors Investment Corp (NYSE:TWO) has. Further, as interest rates increase, MSRs will increase in value, acting as a hedge against the drop in book value due to the company’s Agency MBS.
Future Investments
The company expects to invest 50% of the recent capital raise into purchasing Agency mortgage backed securities, while 30% will be put into either high yielding non-Agency MBS or credit sensitive loans. The remainding 20% will be invested in mortgage servicing rights (MSRs). Two Harbors’ reliance on Agency MBS is expected to decrease with time as other asset classes get a chance to develop. However, its MSR investment is uncertain given the less liquid nature of that market.
Competition
Two Harbors Investment Corp (NYSE:TWO) competes with other mortgage REITs, including American Capital Agency Corp. (NASDAQ:AGNC) and Annaly Capital Management, Inc. (NYSE:NLY). Both American Capital Agency and Annaly Capital Management, Inc. (NYSE:NLY) are exclusively invested in fixed rate residential mortgage backed securities for which interest and principal payments are guaranteed by any of the government Agencies. However, the investment portfolios of both vary. American Capital Agency Corp. (NASDAQ:AGNC) possesses a portfolio that has high prepayment protection attributes. Its portfolio is low coupon, HARP eligible, and has low loan-to-value securities. These attributes have led American Capital Agency Corp. (NASDAQ:AGNC) to report one of the lowest CPRs during times of accelerated refinancing.
On the other hand, Annaly Capital’s bottom line was hurt significantly during the past two quarters due to accelerated refinancing. The refinancing accelerated prepayments on Annaly’s securities. Annaly Capital Management, Inc. (NYSE:NLY) has a portfolio composed of high coupon and high loan-to-value securities. This is why its portfolio is more exposed to prepayments. It reported 19% CPR at the end of the fourth quarter of the prior year, which is one of the highest among pure-play mREITs.
Conclusion
Despite the fact the Two Harbors Investment Corp (NYSE:TWO)’ price target has been downgraded by Credit Suisse, I believe the stock offers growth potential. Therefore, I recommend it as a buy. The MSR approvals will bring attractive returns during the prevailing environment where interest rates are increasing. Besides, MSRs will act as a hedge against a drop in book value. Therefore, the target price reduction should not be a concern.
Adnan Khan has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.
