CHMI - Cherry Hill: The 15.4% Yield Faces Headwinds Consider The Preferreds

Summary

• Cherry Hill's quarterly dividend payout currently stands at a double-digit 15.4% yield, with its last quarterly payout at $0.27 per share.
• This has been cut back materially in recent years and faces further headwinds in 2023 as the Fed funds rate continues to rise.
• The Series B preferreds offer a 9% yield on cost and are trading at a nearly 10% discount to their par value.

Cherry Hill Mortgage ( CHMI ) is a highly diversified hybrid residential mortgage REIT that last declared a quarterly cash dividend payout of $0.27 per share , in line with its prior payout for a 15.4% yield. You'd be right to question the health of a double-digit yield on an mREIT against the broader macroeconomic conditions we've witnessed over the last two years.

This has faced continued downside pressure, with the current quarterly payout at a significantly reduced level to the mREIT's pre-pandemic averages. Several factors were at play here, from the rapid margin calls handed out to mREITs during the early pandemic panic to the current inflation crisis. Both of these factors continued almost uninterrupted and have not provided the slack required for Cherry Hill to recover. The mREIT's future is now under increased uncertainty and its yield looks primed for a reduction.

Book Value Is Under Pressure As Interest Rates Rise

The externally managed Farmingdale, New Jersey-based mREIT invests in and manages residential mortgage assets in the US. The core focus of Cherry Hill is its payout with capital appreciation being a secondary objective, an important distinction as the performance of the commons over the last few years has pulled lower due to a book value that's been in decline.

The company's book value per share was $6.05 at the end of its last reported fiscal 2022 third quarter, down sequentially from $6.73 per share in the second quarter and from $9.07 per share in the year-ago comp. A 10.1% quarter-over-quarter decline highlights the extent of the pressures Cherry Hill faces. The operating model is straightforward, the company borrows money and uses this to invest in assets. These assets were formed from mortgage servicing rights ((MSR)) and agency residential mortgage-backed securities ((RMBS)). The latter is backed by mortgages issued by government-sponsored agencies like Freddie Mac or Fannie Mae.

The mREIT also states it sometimes opportunistically invests in the fixed and floating-rate tranches of non-agency RMBSs. Agency RMBS was the largest component of the portfolio with a value of $938.7 million at the end of the third quarter.

GAAP net income was $38.3 million, around $1.90 per share to drive earnings available for distribution ((EAD)) of $5.1 million, or $0.26 per share. This was down 7.14% from EAD of $0.28 per share in the second quarter. Critically, the current EAD is around $0.01 below the last declared dividend to raise the specter of a cut. This uncertainty is increased further with book value and net income under some pressure due to the rising Fed funds rate that required extensive hedging through interest rate swaps, TBAs, and Treasury futures. The mREIT held interest rate swaps with a notional amount of $1.3 billion at the end of the quarter. With the current yield likely not safe, the preferreds offer an alternative.

The Series B Preferreds And A 9% Yield On Cost

Cherry Hill Mortgage 8.25% Series B Fixed-to-Floating Rate Cumulative Preferred Stock ( CHMI.PB ) pays a $2.06 annual coupon, distributed quarterly, for a 9.09% yield on cost. Preferreds should form a part of any dividend investor's portfolio, as they offer a stable form of fixed-income exposure wrapped within an easy-to-trade security that provides more priority to Cherry Hill's earnings than its commons.

There are a number of features to like here. They're currently trading at $22.66, a 9.36% discount to their $25 par value, with around a year and two months left until their redemption date. There is no obligation for Cherry Hill to redeem the Series B on April 15, 2024, and the coupon rate as of this date changes to a floating rate of three-month LIBOR plus a spread of 5.631% per year. Three-month LIBOR currently stands at 4.85%, up from 0.37% a year ago. The current rate hike cycle is not yet over, with at least two more 25 basis point increases to the Fed funds rate expected. This sets the backdrop for what could be a double-digit coupon rate on the Series B next year.

Holders of the preferreds are essentially now able to grab a security with a 21.7% yield to call and with a cumulative clause which all but ensures there is no risk to the total dividend they will receive. Hence, these might be a good addition for an income investor looking for mREIT exposure with an inherently lower risk profile than the commons.

The preferreds are up by 7.85% on a total return basis over the last three years versus a negative return nearly at 30% for the commons. I expect this outperformance to persist throughout this year and into 2024 as inflation remains elevated beyond the Fed's 2% target rate and their funds rate remains higher for longer. This will pose headwinds to Cherry Hill's book value and the overall health of its earnings and dividend coverage. Whilst I'm not looking for mREIT exposure at this time, I'd likely go with the preferreds over the commons if this position changes in the near future.

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