PMT - PennyMac: And Now For Something Different For Preferred Holders

2023-08-29 14:44:47 ET

Summary

• PennyMac Mortgage has announced that its preferred securities will not transition to a floating rate and will remain pegged to existing fixed rates.
• The decision has sparked debate over the legality and interpretation of the LIBOR Act and prospectus language.
• In our view, while unfortunate, there is nothing plainly illegal about this.
• Investors may consider alternative mortgage REIT preferreds such as Arbor Realty and Rithm Capital which are anchored off non-LIBOR rates.

As many PennyMac Mortgage ( PMT ) preferred investors may be aware, the company issued a press release the other day informing shareholders that the securities will not transition to a floating rate but will remain pegged to the existing fixed rates.

The title of our article refers to both the fact that PMT is doing something that very few other issuers of Fix/Float preferreds have chosen to do (i.e., fail to transition to a floating rate) as well as suggest other hybrid mortgage REIT preferreds that investors should consider.

Why The Fixed Peg?

As expected there were some hot takes immediately after the press release. Interestingly, these takes disagree. Our own view is that, while unfortunate and against the spirit of the preferreds, there is nothing obviously illegal or insane about the ability of PMT to forgo switching to a floating rate and, instead, stick with the original fixed rates.

The view that PMT is not allowed to do this seems to hinge on an odd reading of the waterfall which simply removes any mention to LIBOR. In our view, simply crossing out LIBOR provisions in the prospectus is clearly not appropriate. It is not appropriate because the LIBOR Act distinguishes between so-called tough legacy contracts and other contracts, applying only to the former. If we simply cross out any mention of LIBOR in the prospectus how can we tell what is a tough legacy contract and what is not?

Second, there is third-party commentary (mind you, issued by a news agency not a law firm) which says that the LIBOR Act requires the statutory replacement to be based on SOFR. However, some analysts take this to mean that LIBOR coupons must be changed to SOFR. This is not the intent of the wording nor the LIBOR Act. The wording "requires the statutory replacement" in our view just says that if LIBOR is to be replaced by something new that something should be SOFR.

Why do we think this? This is because the LIBOR Act allows issuers to use floating rates other than SOFR if those rates are mentioned in the prospectus. For example, it is perfectly fine for a preferred to switch to the Prime rate or the Fed Funds rate if those are the explicit fallbacks in the prospectus. SOFR would be used in the tough legacy contracts that do not specify an existing floating rate. This clearly means that the phrase "LIBOR Act requires the statutory replacement to be based on SOFR" is plainly incorrect.

The key point, if our understanding is correct, is that the LIBOR Act does not override the existing prospectuses. It simply allows a safe harbor for issuers who wish to keep the floating-rate economics of their contracts. In other words, a LIBOR-based preferred can be switched to a SOFR rate, against the explicit fallback provision of the prospectus, without the fear of the issuer being sued for this. In short, the original dividend fallback in the prospectus remains in force, but issuers also have the option to switch to SOFR even if SOFR is not mentioned in the prospectus.

All of this is our, however informed, view. Investors don't have to believe this. However, investors need to understand that PMT is not the only issuer that has gone this route. So has Morgan Stanley - not exactly a minnow in the world of fixed income.

Let's compare the key bits from the LIBOR fallback language between PMT and MS preferreds.

PMT

If fewer than three New York, New York banks selected by us quote rates in the manner described above, the three-month LIBOR for the applicable dividend period will be the same as for the immediately preceding dividend period, or, if there was no such dividend period, the dividend shall be calculated at the dividend rate in effect for the immediately preceding dividend period .

MS

If the banks so selected by the calculation agent are not quoting as set forth above, LIBOR for that dividend determination date will be the same as LIBOR for the immediately preceding dividend period, or, if there was no such dividend period, the dividend payable will be based on the initial dividend rate .

In other words, if LIBOR cannot be sourced from banks (something we know with 100% certainty), the dividends will stay at their original fixed-rate levels. Yes, the "the dividend rate for the immediately preceding dividend period" is not identical to "the initial dividend rate" but it gets to the same result. Analysts who arrive at a different conclusion have to rip up parts of the prospectus - something the LIBOR Act does not intend in our view.

The view that PMT is plainly not going to be able to get away with this need to also explain why no one is making any noise (to our knowledge) about MS. And if MS can stay with a fixed dividend then so can PMT.

Some Alternatives

After this announcement the prices of the two (previously) Fix/Float preferreds fell around 4%. The full suite of the three preferreds now looks like the following. The reason for the drop in prices was to allow stripped yields to converge since it is very likely A and B will turn into fixed-rate stocks.

Interestingly, their stripped yields are still around 0.2% below that of C - which makes sense given some chance that the failure to transition to a floating rate will not stand and A and B dividends will increase in the future once they move to a floating-rate level, unless redeemed.

What should A and B investors do? One obvious possibility is to do nothing. Current yields of 9%+ are pretty attractive within the mREIT preferred space and more broadly (not to mention the small probability of dividend upside as just mentioned). The company's book value has fallen around 20% since 2020 which sounds bad but is actually a pretty good result in the sector. Recall that a stable book value supports preferred equity coverage. The company's leverage is a bit above the median of hybrid mREITs while equity coverage is in line with the median.

While it may be disappointing to miss out on the potentially higher future yields of A and B shares, some investors thought they might get, locking in a fixed yield north of 9% is not a terrible proposition, particularly since short-term rates are very likely to fall in the future.

That said, it's also understandable if investors are once burnt, twice shy and want to avoid PMT preferreds. Preferreds that are less likely to go down the fixed-dividend PMT route are those of issuers who have already signaled their transition to floating rates, preferreds which are fixed-rate by definition and preferreds that were anchored off a different floating rate (e.g., 5Y CMT or SOFR) at issuance.

It's also important to consider the specific business profile of the given mREIT. Specifically, we can roughly divide the hybrid (i.e., non-Agency) mREIT space into those that tend to just hold loans and those, like PMT, that hold loans and do a bunch of other stuff, particularly origination. In this segment investors should consider issuers like Arbor Realty ( ABR ), Ready Capital ( RC ) and Rithm Capital ( RITM ).

Among these, we like the following stocks:

• Rithm Series D (RITM.PD), trading at an 8.4% stripped yield with a Nov-2026 first call date when the coupon switches to 5Y CMT + 6.22%, unless redeemed.
• Arbor Series F (ABR.PF), trading at a 7.8% stripped yield with an Aug-2026 first call date when the coupon switches to a SOFR + 5.442% rate.

The forward yield profile of the two stocks, based on current forward rates, looks like the following.

Another advantage of these stocks is that they are not LIBOR-based and so will not have the unpleasant surprises of PMT.

For further details see: