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Better Buy After Earnings: Annaly Capital Management or Two Harbors Investment Corp.?

The overall market surged in 2013 while big name mortgage REITs like Annaly Capital Management  (NYSE: NLY  ) and Two Harbors  (NYSE: TWO  ) posted negative total returns. However, much of the volatility that plagued the bond market in 2013 smoothed out considerably in the first quarter. 

Despite the more normal environment, weak first quarter results mixed with the potential for rising interest rates to devalue company assets have beaten the companies' stocks down. This makes now the perfect time to dig into what happened, and determine which company is better positioned for future success. 

The asset mix
The story on Annaly over the past year has been its low leverage – total debt divided by total stockholder's equity. While less borrowing and a smaller portfolio reduces risk, it won't help move the needle. 

Annaly broke the trend in the first quarter and increased leverage from 5 times equity to 5.2 times. This is still lower than peers, but allowed the company to grow its portfolio by about $4 billion -- from $73 billion last quarter to $78 billion. This is a good sign that the company is starting to see real opportunity. 

Annaly has also been diversifying into commercial real estate, and is currently holding $1.7 billion in total. That's not a large percentage of total assets, but it's an asset class that the company is excited about. The yield on commercial real estate was over 9%, compared to just over 3% on the company's bread and butter: agency mortgage-backed securities (MBS.)  

Two Harbors, unlike Annaly, has a more diversified portfolio. 

Thirty-year agency MBSes still run the show, but during the company's first quarter conference call management seemed most excited about the development of a pipeline for buying mortgage serving rights (MSRs.) Essentially, the company is buying the rights to "service," or act as a middle man between the borrower and lender. 

Two Harbors doesn't actually do the servicing. Rather, the company buys the rights, contracts out the actually job, and earns a small fee. Two Harbors' Chief Investment Officer suggested that by developing their MSR capabilities "we can create sustainable franchise value for our stockholders." 

What's the spread?
mREITs earn the difference between what it cost to borrow, and the yield on assets. This is referred to as the net interest rate spread.

Net Interest Rate Spread-Q1 2014 (Q4 2013)
Company Borrowing cost Average Yield Net Interest Rate Spread
Annaly Capital  2.3% (2.1%) 3.2% (3.5%) 0.9% (1.4%)
Two Harbors 1.2% (1.1%) 4.2% (4.1%) 3% (3%)

During the first quarter, Annaly had an increase in interest rate swap expenses on the borrowing side and increased amortization on the yield side. Both of these factors negatively affected the spread. 

The story looks considerable different for Two Harbors. The company didn't have the extra expenses on swaps, nor did it have the same amount of decline in value of securities. In fact, over the last year, Two Harbors has managed to keep borrowing costs extremely low. 

The last word
The first quarter had little effect on my Annaly thesis. The company is fairly defensive in the face of possible rising interest rates. However, the dividend remained steady, it is still trading at a fair valuation, and Annaly has plenty of room to increase leverage and grow assets if opportunity arises. I believe it's well positioned itself. 

With that said, Two Harbors is your better buy today. The company has consistently outperformed its peers, its borrowing cost have been consistently low (which is an incredible advantage), and it has more flexibility to find greater yields outside of agency MBSes. To add a cherry on top, I think with the company's trading near book value -- total assets minus liabilities -- it's a very good value.

Are these a better dividend option than mREITs?
The smartest investors know that dividend stocks simply crush their non-dividend paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here now.

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Dave Koppenheffer

Dave Koppenheffer, is a contributor for the Motley Fool's financial sector. And much like Dwayne "The Rock" Johnson, when he speaks, he speaks with an earnest vibe and an earnest energy.

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Related Tickers

8/27/2015 3:34 PM
NLY $10.17 Up +0.19 +1.90%
Annaly Capital Man… CAPS Rating: ****
TWO $9.61 Up +0.09 +0.95%
Two Harbors Invest… CAPS Rating: ****