Company Description

Hatteras Financial Corp. (NYSE:HTS), like its fellows Annaly Capital Management, Inc. (NYSE:NLY) and American Capital Agency Corp. (NASDAQ:AGNC) is a pure play Agency mortgage REIT. The company, with a market cap of $2.7 billion, owns assets with short durations and predictable prepayment characteristics. Company policy dictates the management to distribute 100% of its taxable income.

Asset Portfolio

Hatteras has both fixed rate and adjustable rate Agency securities in its portfolio. The graph below shows the proportion of each security in the company’s portfolio. Fixed rate form only 17% of the MSB holdings, while the rest rate ARMs.

Many of the securities owned by the company have low coupons, compared with the weighted average coupon rates of Annaly Capital Management and American Capital Agency. The company’s adjustable rate securities have a weighted average rate coupon rate of 3.07%, while the fixed rate securities have a weighted average coupon rate of 2.63%. Therefore, according to my calculations, the weighted average coupon rate for the entire MBS portfolio comes out to be around 3%. The company reported a conditional prepayment rate of 27.6% at the end of the third quarter of the prior year. In comparison, Annaly Capital has an MBS portfolio with a weighted average coupon of 4.1% with prepayments speed of 20% at the end of the third quarter, while the average coupon and CPR for American Capital Agency are 3.86% and 12%, respectively.

Recent Performance

Net interest income totaled $79.6 million during the third quarter of 2012. The net interest spread for the quarter was 122 bps, 27 bps lower than the prior quarter. The asset yield declined by 27 bps in the quarter. Average cost of funds was flat quarter over quarter at 0.94%. As a result core EPS came out to be $0.72 per common share, $0.09 lower than the estimates of Credit Suisse. Lower asset yields were blamed to be the reason for such a miss.

Dividends

The company announced quarterly dividends of $0.7 per common share yielding 10.35%. The quarterly dividend dropped from $0.8 in September 2012. The company paid $256 million in dividends during the third quarter, while it generated $335 million in cash from operations. The cash dividend coverage ratio comes out to be 1.3 times, reflecting the fact that the company still has some room before another dividend reduction can be expected.

Valuations

Hatteras is currently trading at 0.91 times its third quarter book value, compared to 0.89 times and 0.97 times for Annaly Capital and American Capital Agency. Armour Residential is trading at 0.88 times its third quarter book value.

Conclusion

Hatteras Financials is yet another pure play Agency mortgage REIT that is close to the hearts of investors for its elevated dividend yield. The offered dividend yield appears to be sustainable and I believe going forward, the company will face slowdown in prepayment speeds. The abundance of ARMs in the company’s MBS holdings give Hatteras Financial an advantage over Annaly Capital and American Capital, which own large chunks of fixed rate securities exposed to higher prepayments. Therefore, I recommend investors buy Hatteras Financial and benefit from the elevated dividend yield.

The article Don’t Miss This Exciting 10% Yielding mREIT originally appeared on Fool.com and is written by Adnan Khan

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