We cover many of the preferred shares and baby bonds in the mortgage REIT sector, along with the common stocks. Today, we will be going over a baby bond from Two Harbors (TWO).

Baby Bond (TWOD)

We recently purchased shares of TWOD, which offer an attractive yield to maturity.

I want to keep money allocated into shares paying us an attractive rate. TWOD has an attractive 9.375% coupon and is trading slightly over the maturity value of $25.00.

I believe it is far more likely than not that TWO will be acquired by CrossCountry and that will result in TWO making an offer to repurchase these baby bonds at $25.25 plus accrued interest. That probably happens later this year. So, we end up with a trade (based on our $25.19 and $25.20 execution prices) that most likely gives us a bit better 9.4% annualized for the next several months. I’m happy with that.

It appears that the prices are about $.10 higher today than at the time of our transaction. However, our transaction was 11 days ago, so there’s an extra $.07 of interest accrual today. Consequently, the gap is only about $.03 after adjusting for dividend accrual.

Normally, the call value would be $25, but in the event of a buyout, the baby bond would pay out 101%. Here is how it is mentioned in the prospectus:

If a Change of Control Repurchase Event (defined below) occurs, unless we have exercised our option to redeem the notes as described above, we will make an offer to each holder of notes to repurchase all or any part (in a principal amount of $25 and integral multiples of $25 in excess thereof) of that holder’s notes at a repurchase price in cash equal to 101% of the aggregate principal amount of notes repurchased plus any accrued and unpaid interest on the notes repurchased to, but excluding, the date of repurchase. Within 30 days following any Change of Control Repurchase Event or, at our option, prior to any Change of Control, but after the public announcement of the Change of Control, we will give notice to each holder with copies to the trustee and the paying agent (if other than the trustee) describing the transaction or transactions that constitute or may constitute the Change of Control Repurchase Event and offering to repurchase notes on the payment date specified in the notice, which date will be no earlier than 30 days and no later than 60 days from the date such notice is given.

Main Risk

The potential risk would be if TWO were to be acquired by UWMC instead. In that case, I think it would be less attractive because UWMC’s credit quality is weaker. Currently, we believe the most likely outcome is that TWO gets acquired by CrossCountry Mortgage, given the latest agreement in late March. UWMC continues to pursue a competing proposal, but we believe it has a materially lower probability.

When evaluating preferred shares and baby bonds, we like to look at the ratio of common equity to preferred and baby bond liquidation. Generally, the higher this ratio is, the safer the securities are. In this case the ratio is 11.14x when only looking at the coverage for baby bonds. That means common equity divided by the baby bond call value (same as theoretical liquidation value). Because baby bonds have seniority over preferred shares, we do not count preferred shares when running the ratio for common equity to baby bonds.

This is one of the best coverage ratios for baby bonds in the mortgage REIT sector. In some rare instances, this ratio can get extremely low for baby bonds.

Other Risk

If we get close to the acquisition date, I think TWOD will trade very close to the expected buyout price. However, the terms require that the company make an offer to repurchase the shares at $25.25 plus accrued interest. It does not state that the company will force the transaction on investors. If investors do not sell the investment or accept the offer for their shares, then they would have the debt of the private company. That could still be acceptable, but it may be much harder to exit positions.

I’m leaning towards using the offer to repurchase shares.

Of course, it is also possible that the deal could get blown up entirely. In that case, TWOD would simply continue to be a baby bond from a mortgage REIT paying an attractive yield. That’s still an acceptable outcome.

Disclosing The Trade

There are plenty of analysts who tell you what you should or shouldn’t buy. We also like to provide full transparency for our subscribers and let them see exactly when we are purchasing or selling shares. For those interested, I will post the details of the trade for TWOD:

We view TWOD as an attractive opportunity with a strong yield. We also believe there is a favorable potential outcome if the CrossCountry transaction goes through. In the event the acquisition does not go through, investors would still own a baby bond from a mortgage REIT offering a compelling yield. Our Google Sheets are showing a "Hold" rating for TWOD. However, almost all preferred shares and baby bonds are currently in our "Hold" range. We view TWOD as a good "Buy" relative to the other baby bonds and preferred shares in the sector.