Sailing Into Two Harbors

 | Jul 29, 2011 | 11:33 AM EDT
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After jettisoning Chimera (CIM) last month, I'm taking another stab at a high-yielding mortgage real estate investment trust.

Two Harbors (TWO) has an indicated yield of 15.4%, and throws off the cash by managing a portfolio of both agency and non-agency residential mortgage-backed securities (RMBS). Considering the moribund state of the housing market, this bet sure feels like it's taking on risk for the yield. But insiders appear adamant that their business model is based on solid assets.

In June alone, nine executives and directors at Two Harbors bought more than $2 million worth of company shares at an average price of $10.64. That was after a large wad of insider buying back in February of this year, and November and August of last year. All the buyers increased their holdings notably with the June purchases. The majority of insiders also averaged up the cost of their holdings, having previously bought TWO as it traded sub $9 and sub $10 last year.

As my Chimera experience warns, perceptions of risk in the portfolios of these REITs can change quickly -- for better or worse. When assessing Two Harbors' risk, I was impressed with how steadily its shares had traded in the past year. That's related to the company's dividend staying steady over the past three quarters at $0.40 a share. By comparison, Chimera, with its historic focus on the non-agency side of the business, wasn't able to manage the turbulence in its markets without reducing dividends over the past three quarters.

A Nimble Ship

Two Harbors' history of navigating within varying areas of both the agency and non-agency markets of RMBS is a major reason for its dividend's stability.

"Management is very opportunistic," says Bose George of Keefe Bruyette & Woods, who rates TWO a Buy. "The company invests in different types of non-agency paper, and gets to see a lot more opportunities. Other mortgage REITs stick to prime and Alt-A investments."

While that can lead to a riskier pool of assets, George said he believes Two Harbors has "built an attractive portfolio hedged for interest-rate risk."

Illustrating its opportunistic bent, Two Harbors hired Diane Wold in May to launch a new securitization business, and announced its intention to complete $250 million in RMBS securitization by the end of 2011. That's quite a move, considering the blowup of the securitization market during the financial crisis. Bose also points out that there have only been two securitizations of new prime loans since 2007 because of the demise, and both were done by Redwood Trust (RWT).

To fund the opportunities it sees in all its markets, Two Harbors has been busy raising cash this year. The firm has had three equity offerings so far in 2011: 28.75 million shares sold in March, 23 million at the end of May and 48.3 million shares last week. Each offering understandably caused TWO to decline due to dilution. So far, the stock has managed to recover afterwards.

It's likely that Two Harbors' most recent offering has opened up yet another buying opportunity in its shares. And taking advantage of these dips is important, since investors aren't likely to get more than 10% in capital gains in TWO over and above the security's yield, even at their suddenly lower price.

Ladenburg Thalmann's David Walrod also has a Buy rating on TWO, and he says the firm's move into securitization is a good one -- though it won't add significantly to results in the near term.

"The biggest risk to the stock remains interest-rate risk," says Walrod. "Hedging can't remove that risk completely, and I expect a knee-jerk reaction of selling the entire REIT group when rates finally do rise."

The risk is not insignificant as U.S. politicos trip over themselves to give ratings agencies an excuse to downgrade the country's credit worthiness. But Two Harbor and its peers will hardly be the only group affected if and when the dysfunction in Washington produces such consequences.

For investors looking for a high-yield play, Two Harbors holds water.

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