Superior Yield From a Real Estate Play

Hatteras Financial Corp (NYSE: HTS) is a North Carolina-based mortgage real estate investment trust (mREIT) that invests in agency mortgages guaranteed by US government-sponsored mortgage entities such as Ginnie Mae, Fannie Mae and Freddie Mac.

Hatteras raises capital for its investments from public offerings of common stock, preferred stock and low-interest debt (short-term repurchase agreements). Hatteras started operations in November 2007 and has been a public company since April 2008.

An externally managed mortgage REIT, Hatteras’ profits derive primarily from the higher interest it earns on its investments relative to the lower interest paid on short-term borrowings.

As of June 30, Hatteras had total investments of $23.3 billion, total debt of $20.1 billion and total equity of $2.7 billion, up from $2.1 billion on December 31, 2011 and significantly more than its December 2008 equity level of $736.3 million. It’s fair to say, based on historical data, that Hatteras has consistently grown its equity base.

Much like other REITs, Hatteras depends on debt and leverage for its returns. Its debt (including Preferred Shares) to equity ratio stands at about 7.49, down from 7.77 and 7.58 over the last two years. Hatteras shares have a book value of $27.45 while its common stock traded at $29.67 as of September 21, 2012.

As a REIT, Hatteras pays out over 90 percent of its earnings as dividends, with a payout ratio of 100 percent over the first half of 2012, when it earned $1.80 per share and paid out $1.80 as dividends ($3.60 annualized). With shares trading at $29.67, Hatteras’ common shareholders receive a dividend yield of 10.9 percent. Over the past five years, Hatteras’ common shareholders have benefited handsomely from double-digit dividend yields and some nominal share price appreciation (roughly 3.3 percent annually, about in line with inflation).

Another way for investors to play this company is through its more bond-like Series A Preferred Stock (NYSE: HTS-PA). On Aug 16, 2012, Hatteras priced 11.5 million Series A preferred shares at $25 each. These shares trade publicly, carry a 7.625 percent dividend yield (also called the coupon rate) and are Cumulative and Redeemable.

The cumulative feature ensures that preferred stock holders are paid past dividends owed, beginning August 27, 2012, payable quarterly (around the 15^th of January, April, July and October with the first prorated payment due October 15, 2012) and amounting annually to $1.90625 per share.

The redeemable feature states that these preferred shares may not be redeemed before August 27, 2017, except under special circumstances that involve a change of control (a merger or acquisition). Under such change of control, the preferred shares may be converted into common shares under a conversion formula of x/y where x = ($25 + accrued and unpaid dividends) and y = the price of HTS common shares – up to a maximum of 1.7519 common shares to be issued per preferred stock.

Hatteras plans to use the $278.2 million in net proceeds from this offering to purchase short-duration mortgage backed securities—hybrid adjustable rate mortgage securities (hybrid ARMs) maturing between 3 and 10 years, and 10- to 15-year maturity fixed-rate mortgages. Proceeds may also be used to retire outstanding debt, establish hedging positions or for general corporate use.

Hatteras Preferred shares traded at $25.28 as of September 21, 2012, with a slight premium (over their $25 price) reflective of the 7.625 percent dividend yield and the 5-year non-redemption lock-in.

Hatteras’ preferred shares offer a stable and reasonably high dividend yield of 7.625 percent relative to most debt securities in the market. But they also carry some interest rate risk. Interest rates are currently almost as low as they can get and will likely only move higher in time.

If rates rise, Hatteras preferred shares could lose value over the years and trade at a discount to their $25 price. Investors should think of these preferred shares as the equivalent of bond investments that drop in value when interest rates rise—preferred stocks generally have the same interest-rate sensitivity as bonds.

Meanwhile, Hatteras common shares appear to be financially stable with low risk of default. Its preferred shares, however, could lose attractiveness and drop in value if interest rates rise. This would effectively increase their yield but result in capital losses for existing investors. I recommend buying HTS up to $30.25.

Disclosure: I am personally long on Hatteras (HTS) common shares.

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Todd Johnson publishes Dividend Lab, a web site focused on income investing.

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