PMT - PennyMac Mortgage: The 12% Yield Comes With A 17% Discount To Book

2023-06-20 03:09:42 ET

Summary

• PennyMac is paying out a 12% dividend yield to common shareholders.
• The mREIT's payout ratio currently stands at 80% with the commons swapping hands at a 16.7% discount to their fiscal 2023 first-quarter book value.
• Prospective shareholders should consider the Series B preferreds, which are set to float next year in June, for what could be a double-digit yield.

PennyMac Mortgage ( PMT ) last declared a quarterly cash dividend of $0.40 per share , in line with its prior payment and for a 12% forward annualized dividend yield. This yield has been pushed to a 3-year high on the back of the intense disruption of the US mortgage market sparked by the Fed funds rate being hiked to its highest level since 2008 at 5% to 5.25%. Ten consecutive rate hikes have now given way to a pause at the June FOMC meeting with PennyMac's common shares up 4.3% year-to-date. How much more room does the mREIT have to run through 2023 with total returns currently at 8%?

The double-digit yield currently sits close to a 3-year high with the payouts proving resilient and bouncing back quickly from their early pandemic cut. Externally managed and Westlake Village, California-based PennyMac operates in the residential mortgage market. The mREIT acquires residential mortgages originated by third parties as well as the right to service mortgage loans.

A Secured Dividend Payout

The mREIT is focused on investing across three different segments. Credit sensitive strategies did the heaviest lifting during the first quarter with a pretax income of $57.3 million versus a loss of $7 million by interest rate sensitive strategies and a $1.8 million gain for correspondent production. The overall portfolio drove net investment income of $90.37 million , up 10.4% from $81.84 million in its year-ago comp but a miss by $5.03 million on consensus estimates.

Net income attributable to common shareholders was $50.2 million, around $0.50 per diluted share, and up from a loss of $0.32 per share in the year-ago comp. This was with as the mREIT saw its book value per share increase sequentially by $0.18 to $15.96 as of the end of the first quarter. Hence, the commons are currently swapping hands at a 16.7% discount to book value, or around 83 cents on the dollar against an 80% payout ratio.

The Series B Fixed-to-Floating Rate Preferreds

PennyMac's 8.00% Series B Fixed-to-Floating Rate Cumulative Preferred Shares ( PMT.PB ) offer an alternative way to play the mREIT. They currently pay out a $2 fixed annual coupon for an 8.7% yield on cost. Whilst this is 330 basis points lower than the yield paid to common shareholders, these preferreds are both cumulative and set to float just before the start of summer next year on their 15th of June 2024 call date. Why would you pick these over the commons?

Firstly, they're up 5.5% on a total return basis year-to-date, underperforming the commons. However, zoom out over 3 years and the preferreds are up 24% versus a total return of 5.5% for the commons. The reasons for the dichotomy in performance highlight the type of investors the respective securities appeal to. The preferreds are more stable and rigid against periods of material economic discombobulation. The commons were rocked by the pandemic with the quarterlies see-sawing before eventually being cut by 15% in December.

The Series B has no maturity date so will trade in perpetuity after the call date next year. This will see them float at a rate equal to 3-month LIBOR plus 5.99% per year. For some context, the 3-month LIBOR rate currently stands at 5.55% to form an implied yield at float of 11.5%. The 3-month LIBOR could be higher at call if the Fed follows up with further hikes after its pause in June. The Federal Reserve policymakers have stated that they could restart hikes as soon as July with the market pricing in a 74.4% chance of rates being hiked 25 basis points to 5.25% - 5.5% at the July 26th FOMC meeting.

I think inflation is likely set for continued falls with lower gasoline and natural gas prices and the August resumption of student loan repayments set to act as major drivers for the continued release of broader inflationary pressure on the US economy. Hence, my expectation is for the Series B to float between 9% to 10% with the Fed likely to follow up with pauses through 2023 and cuts in the first half of next year. The Series B preferreds are also cumulative which reduces to near-zero the likelihood of a coupon suspension as any unpaid coupon would accumulate as a liability on PennyMac's balance sheet for repayment at a later date. They're currently swapping hands for $22.96 per share, a $2.04 difference from their $25 par value. This 8.16% discount to par represents further upside for the preferred holders to capture. Overall, whilst I don't have a position here I'm leaning towards the preferreds as the economy is set to remain suspended in its current abnormal state until inflation falls back to the Fed's 2% target. The commons have a greater upside potential with a higher discount and higher dividend yield.

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