This is an extract from an earlier article at Systematic Income Premium.
The Agency mortgage sector has been buffeted this year by a number of shocks including high interest rate volatility, significant duration extension, market illiquidity and the end of Fed buying. In this article we take a look at the preferred securities of mortgage REIT Two Harbors (TWO). TWO primarily allocates to the Agency MBS sector alongside mortgage servicing rights which provide a natural interest rate hedge.
A Recap Of The Agency MBS Sector
Agency MBS valuations have become very attractive by historical standards. The sector trades at a very elevated spread over Treasuries as the following chart shows – a level that has only been reached historically during periods of severe economic stress.
Secondly, the duration of the Agency MBS sector is as long as it has been this century which suggests that there should be less additional selling pressure from institutional investors who manage their fixed-income portfolio on a duration basis.
And third, Agency MBS convexity has moved to zero which makes it much easier for mortgage REITs to hedge their interest rate exposure. This is for two reasons. First, changes in interest rates no longer require mREITs to significantly rebalance their interest rate hedges in response to changes in MBS duration. Doing so requires mREITs to pay high rates / receive low rates – a version of buying high and selling low – a process which leads to realized losses particularly when interest rate volatility is high. When MBS convexity is zero, Agency MBS duration does not change very much and mREITs don’t have to reshuffle their hedges.
A Look At The TWO Profile
TWO has a relatively unusual profile in the mortgage REIT space with a roughly 80/20 Agency MBS / Mortgage Servicing Rights portfolio. Most of the mREIT sector is composed of mREITs either primarily focused on Agency MBS or primarily focused on resi / commercial loans. TWO has an Agency allocation that is well below that of pure Agency mREITs like AGNC and DX but well above Hybrid mREITs like CIM or NYMT.
This kind of profile is not unheard of and makes a lot of sense. The two types of securities have different duration profiles – Agencies positive and MSR’s negative. The reason MSRs have negative duration is because when interest rates rise, mortgage maturities tend to extend because they are less likely to be refinanced. And because MSRs are basically fee annuities of mortgages, they rise in value because the period over which the servicing fees are paid increases.
A key reason why we like TWO in the Agency MBS space is that they have been willing to perform actions that are friendly to preferreds holders. These actions were clearly not motivated primarily by the interests of preferreds holders but the fact that they still happen does make TWO attractive.
Specifically, TWO has been willing to support their preferreds every time equity / preferred coverage approached a level of 3x (i.e. $3 of equity for each $1 of preferred liquidation preference), by either retiring preferreds (Series D and E in Q4-20 despite these stocks trading below “par”) or doing a large common issuance (Q3/Q4-21).
This time around they bought back 2.9m shares of their three existing preferreds or 10% of total outstanding shares – a significant move. This not only supported the prices of the preferreds and increased book value by around 1.5% but also allowed equity / preferred coverage to fall only modestly to 3.2x from 3.4x despite a much larger drop in book value over the quarter.
Stance And Takeaways
At the time of the management call a few days ago TWO book value was already up 6-7% from quarter-end on the back of a downside surprise in inflation and a broadbased rally in fixed-income. If this trend continues it will allow the Fed to pause early next year. This pause will likely reduce volatility in interest rates and improve the valuation profile of Agency securities. This would be a nice backdrop to have for allocating to the Agency MBS space.
The TWO preferreds look like this. The three stocks are all Fix/Float and Libor-based with long-term first call dates.
The yield profile based on Libor forwards looks like this.
Historically, we have tended to favor TWO.PA, however the stock has recently outperformed in the suite and it is trading slightly rich to TWO.PB.
TWO.PA has a very similar yield to TWO.PB but a lower yield after TWO.PB floats. For this reason we find TWO.PB a more attractive option in the suite at the moment.
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