Like Superman and Kryponite, high-yield stocks like Annaly Capital Management (NLY 0.61%) and American Capital Agency (AGNC 0.22%) have a weakness for rising interest rates. So, with the Federal Open Market Committee -- in charge of interest rate policy -- predicting an increase interest rates in 2015 (link to PDF on predictions), I think it's time to find a better option.
Two Harbors Investment Corp. (TWO 1.02%), also a mortgage REIT, not only has a comparable dividend yield of 10.5%, but it doesn't share this weakness nearly to the same extent. As you can see above, when 30-year mortgage rates spiked in mid-2013 Annaly and American Capital Agency's book values got crushed, while Two Harbors grew its book value.
How do they do it?
Annaly and American Capital Agency invest almost exclusively in "agency" mortgage-backed securities. Because these packages of housing debt are guaranteed against failing, they are considered the gold standard of mortgage assets.
If long-term interest rates (mortgage rates) were to rise, however, the securities these companies currently own would suddenly yield less than what investors can readily buy in the market. Therefore, the value of these currently owned securities -- along with book values -- tumble.
Along with investing heavily in interest rate sensitive assets like agency securities and prime jumbo loans – very large and high-quality home loans -- Two Harbors separates itself by also investing in a more diverse array of mortgage-related assets that are less sensitive to interest rates.
High on the list are "non-agency" securities. With the exception of also being pools of housing debt, these assets are everything agencies are not. They tend to be more unique in loan size and credit quality, they earn a greater yield, and they are riskier because these securities are not protected against default. Due to the threat these assets could fail, their values are tied more heavily to the strength of the economy and housing market, and not interest rates.
Making up only 3% of Two Harbors' portfolio, but still very important, are mortgage servicing rights (MSR). While the mortgage lender and borrower garner much of the attention, servicers ensure that payments get from A to B. Two Harbors buys the "rights" to service loans, contracts out the task, and pockets whatever is left over. Although the servicing fee is fairly small, it adds up quickly on $46 billion worth of loans. In the second quarter alone, Two Harbors earned $27.6 million in servicing fees.
Moreover, because Two Harbors owns the rights to service the entire life of the loans, the longer it lasts the more money they make. This is where prepayments come in. When interest rates fall, borrowers are more likely refinance their mortgage, which shortens the duration of the loans. Conversely, when rates rise borrowers are less likely to refinance, and the length of the loans extends allowing the company can cash in for longer.
Why doesn't everyone own these assets?
It is no secret that non-agencies and MSRs can perform well in a rising interest rate environment, but despite this fact many companies steer clear because of price and risk.
78% of Two Harbors' non-agency assets are sub-prime mortgages – risky loans to customers with iffy credit – which even in the best scenarios can be dicey. This becomes especially true when the mortgage market is strong, and investors forget these are called "sub" (below) "prime" (high-quality) for a reason and start overpaying.
As for MSRs, along with simply being outside some company's core strategy, when the mortgage market is improving the price tag on these assets can also get expensive.
The Two Harbors' advantage
Two Harbors' versatility to buy whatever asset is most attractive at the time is their ultimate advantage. The company purchased sub-prime mortgages at dirt cheap prices following the financial crisis. They focus on agency securities with lower risk of prepayment -- which creates more predictable income -- and in 2013 they moved into buying prime jumbo home loans when that market was bouncing back.
Today, along with continuing to focus on prime jumbo loans, Two Harbors has turned its attention toward MSRs because of their interest rate durability.
Ultimately, because of their more durable assets and opportunistic management team, I see Two Harbors as one of the best high-yield dividend stocks to hold through the future rising interest rate environment.
