Annaly Capital (NYSE:NLY) and Two Harbors (NYSE:TWO) will release their second quarter earnings in the first week of August. I expect that both these companies to beat analyst expectations because of their well diversified portfolios and the expected cut down in their hedged positions.
Allocating the capital to high yielding assets and reducing the hedging costs will drive strong growth in core EPS. I believe the expected earnings surprise and strong growth in core EPS will positively impact the stock price, and now I think is a good time to take positions in these stocks. Moreover, the current macroeconomic outlook is also supportive of mortgage REITs.
Restructuring hedged positions
I believe both these companies will reduce their swap positions, as short term interest rates are expected to remain stable in the near future. In a recent testimony to the Senate Banking Committee, Janet Yellen made it clear that the Fed was not satisfied with economic growth and would continue with its expansionary monetary policy.
Although the U.S. economy has added over 200,000 jobs for five consecutive months, the labor force participation rate remains low. Moreover, growth in wages is missing from the economy.
The overall economy is showing signs of a recovery, but there are some slacks, causing short term rates to stay low for a longer period of time. Such conditions are ideal for residential mortgage-backed securities (RMBS), since they get breathing space as interest rates are expected to remain stable and predictable. Companies could reduce their swaps, which in turn could reduce hedging costs and enhance core EPS.
In the first quarter, Two Harbors increased its net notional principle of swap by almost 86% to $9.5 billion. Such a massive increase in a hedged position makes the company's exposure to book value positive in both rising and falling interest rate scenarios. I believe Two Harbors has opted for a very defensive approach and it will reduce its hedged position to save costs and strengthen its core EPS.
Similarly, Annaly is also expected to reduce its $24 billion short dated swaps. This position was taken to tackle the increase in short-term rates. As the rates are expected to remain low, the position has little value for the company.
Dividends of both companies are not being covered by their core EPS as shown in the figure below. So, it is important for them to increase their earnings to sustain their dividend yields, which is the primary attraction for RMBS investors.
Benefits from diversification
Two Harbors enjoys diversification benefits, both on its asset portfolio and sources of funds. Nearly 42% of capital allocation is toward credit sensitive assets whose net interest margin is significantly higher than the agency RMBS. Mortgage Servicing Rights (MSR) is 12% of capital allocation and it is expected to increase over time. MSR yield is in the high single digits and it also acts as a natural hedge to rising rates.Both credit and MSR yields are higher than traditional agency MBS, which strengthens the company's income statement.
Lastly, on the borrowing side, Two Harbors has become a member of the Finance Home Loan Bank (FHLB) through which it gets access to $1 billion in borrowing, which is better than the repo market because it is cheaper and the duration of the loan is long. This reduces the asset liability duration gap.
Annaly on the other hand has significant investments in commercial MBS. In the first quarter, the capital allocation was 12%, but the management is keen to increase it to 25% because of its high yield of 9.2%. The company also plans to further diversify its portfolio by acquiring triple net lease assets. It will add exposure to restaurants, office, industrial, and retail, which are cyclical and are expected to perform better with improved economic conditions.
The debt-to-equity ratios of Two Harbors and Annaly at 2.9x and 5.2x respectively are lower than their peers as shown below. Therefore, they have room to increase their leverage and take advantage of attractive opportunities.
Both companies failed to meet analyst expectations in the first quarter of the year. But I am expecting a turnaround in this quarter. The companies will restructure their hedge portfolios, which will reduce their costs. Furthermore, the yield on assets will improve due to strategic diversification toward high yielding assets.
Syed Ahmad Hussain has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.