Housing Gridlock Fuels 10% Yielding Two Harbors Preferreds (NYSE:TWO)

Housing gridlock continues with remarkably low transaction volume. Would-be sellers want to hang on to their cheap existing mortgages, so very few people are selling.

Realtors are losing business and homebuyers are frustrated by the lack of suitable homes on the market.

The gridlock is not fun for many participants in the housing market, but it benefits Two Harbors Investment Corp. (NYSE:TWO). With the increased stability from longer duration assets, we believe the preferreds are opportunistic sources of high yield.

The Buy Thesis

Two Harbors has a series of fixed-to-floating preferreds which upon conversion to floating would yield between 9.6% and 10.5% using current SOFR. These well-above market yields are, in theory, justified by TWO being a highly leveraged mREIT, which would imply an above-average level of risk. However, with the freshly extended duration of TWO’s assets, there is a good amount of visibility into its future cash flows, which have ample room to cover the preferred dividends.

As such, I think TWO preferreds are more stable than would typically be available at that level of yield, making them potentially opportunistic as a high-yield play. Since the preferreds trade at discounts to par, there is room for a bit of capital appreciation on top of the yield.

Lengthened Duration and More Stability

Two Harbors has two primary lines of business: Agency RMBS and mortgage servicing rights (MSRs). These asset classes make up the overwhelming majority of its balance sheet.

MSRs and agency RMBS are a natural pairing because they have inverse sensitivity to interest rates. MSRs gain in value as interest rates rise, and RMBS loses value as rates rise.

With this offsetting aspect, Two Harbors is largely resistant to modest changes to interest rates in either direction. This minimized the damage to TWO as mortgage rates shot up to 7%.

However, as mortgage rates rose to 7% and then hovered around 7% for the last couple of years, it ushered in an interesting change to TWO’s outlook: significantly longer asset duration.

There is nothing unique about the 7% level of mortgage rates. Mortgage rates have been around 7% many times historically. What makes this situation different is that rates were so low previously that existing mortgages are overwhelming at very low rates (2%-5%).

People would normally either refinance or pay down mortgages, such that the duration of a 30-year mortgage is often somewhere closer to 10 years. Given the extremely attractive rates of existing mortgages, borrowers will try to extend them to as close to 30 years as they can.

There are 3 main sources of prepayment:

1. Voluntary early payment
2. Refinancing
3. Default

All 3 sources are abnormally low right now.

People don’t want to pay down principal on a 3% mortgage because they would be better served getting a 5% certificate of deposit (CD) and profiting from the spread.

They are also reluctant to refinance, with current mortgage rates well above the level of existing mortgages. There is no financial incentive to refinance and people are even delaying moving so as to keep their mortgages.

Finally, default is also quite low at the moment. According to Mortgage Bankers Association:

Total loans in forbearance decreased by 3 basis points in December 2024 relative to November 2024: from 0.50% to 0.47%.

Among the small percentage of defaults, a higher-than-normal portion is related to natural disasters, likely the hurricanes and wildfires of recent months.

With all 3 sources of prepayment at reduced levels, the duration of 30-year mortgages is significantly extended.

MSRs particularly benefit from longer duration as the right-to-service mortgages are purchased upfront, and then TWO collects a fee for the duration of the mortgage. TWO now has more fee income for longer.

This provides greater visibility into TWO’s future earnings. Fee income from MSRs along with the stream of coupon payments from its agency RMBS provides comfortable coverage for TWO’s preferred dividends.

The Preferreds

On Portfolio Income Solutions, we continually track the universe of mortgage and equity REIT preferreds. Many preferreds are properly priced such that they provide a fair yield relative to the level of risk. A select few are mispriced, and we believe the TWO preferreds (TWO.PR.A) (TWO.PR.B) (TWO.PR.C) are cheaper than they should be. Here are the vitals:

As a quick reminder, the way a fixed-to-floating preferred works is that it pays the face coupon up until the day of conversion to floating, after which point its coupon becomes the floating rate SOFR plus an adjustment.

For example, TWO-A will pay its 8.125% face coupon until conversion to floating on 4/27/27 at which point it will pay SOFR plus a 26 basis adjustment plus 566 basis points. At today’s SOFR, that would be a 10.21% coupon.

Coupons refer to the payout against the $25 par value. Given the discount at which it trades, the yields are slightly higher at 8.31% current yield and then 10.45% yield upon conversion to floating (assuming SOFR stays the same).

All 3 of the TWO preferreds are opportunistic in my opinion.

TWO-A has the largest adjustment over SOFR at 566 basis points, which makes it the one TWO is most incentivized to redeem. As it is trading at a discount to par, redemption is a favorable outcome for investors who would collect the difference as well as the partial period dividend accrued.

TWO-B trades at the largest discount to par which provides about 6% capital appreciation potential to par. These coupons are high enough that even if interest rates remain where they are the market could easily trade it at par.

TWO-C has the advantage of an earlier conversion date. On 1/27/25 it will begin paying its floating coupon of 9.56% which translates to a yield of 9.61%. Given how close this date is, that is functionally its current yield. With a 501 basis point spread over SOFR it is not quite as large of a floating coupon as either the B or the A, but the conversion date is more than 2 years sooner making the dividends likely larger for the next couple of years.

Over time, I suspect all 3 will trade around $25 par.

We have been trading various fixed to floating preferreds for years and quite consistently observed them trading up to par as their conversion dates approach. The main requirements to trade at par seem to be sufficiently large adjustments over SOFR and a stable underlying company. In my opinion, Two Harbors preferreds to check both of those boxes.