AGNCO - PennyMac: Pound Foolish

2023-08-28 10:14:07 ET

Summary

• PennyMac Mortgage Investment Trust announces that two of its preferred shares will not transition to a floating reference rate, impacting their dividend rates.
• The cost savings from this move are expected to be relatively small, and the company may face lawsuits as a result.
• The move is likely to damage investor goodwill and may affect future market demand for the company's securities.

Late Friday news drops are generally not pleasant. You rarely see companies announce positive news at that time. What you do get is companies giving you bad news with the weekend to absorb it. PennyMac Mortgage Investment Trust ( PMT ) had its turn last week and announced that two of its three preferred shares won't be floating with a LIBOR substitute, but will remain at a fixed rate as before. This will impact PennyMac Mortgage Investment Trust PFD SER A ( PMT.PR.A ) and PennyMac Mortgage Investment Trust CUM RED PFD B ( PMT.PR.B ).

In March 2021, the U.K.'s Financial Conduct Authority announced that after June 30, 2023, the USD LIBOR for a three-month tenor would cease publication or no longer be representative. In connection with the cessation of representative USD LIBOR, in March 2022, the U.S. Congress enacted the Adjustable Interest Rate (LIBOR) Act (the "LIBOR Act”), and in December 2022 the Board of Governors of the Federal Reserve System (the "Federal Reserve") issued a final rule thereunder (the "LIBOR Rule”). The LIBOR Rule provides with respect to any reference in the terms of a security requiring a poll or inquiries for quotes or information related to USD LIBOR (“Polling Provisions”) contained in so called “fallback provisions” applicable in the event USD LIBOR is not published, such Polling Provisions shall be disregarded and deemed null and void and without any force or effect.

In accordance with the Articles Supplementary for each of the Series A Fixed-to-Floating Rate Cumulative Redeemable Preferred Shares of Beneficial Interest (the “Series A Preferred Shares”) and the Series B Fixed-to-Floating Rate Cumulative Redeemable Preferred Shares of Beneficial Interest (the “Series B Preferred Shares”), and disregarding the Polling Provisions contained therein, the applicable dividend rate for dividend periods from and after March 15, 2024, in the case of the Series A Preferred Shares, or June 15, 2024, in the case of the Series B Preferred Shares, shall be calculated at the dividend rate in effect for the immediately preceding dividend period. As a result, the Series A Preferred Shares and Series B Preferred Shares will continue to accumulate dividends from and after March 15, 2024, in the case of the Series A Preferred Shares, or June 15, 2024, in the case of the Series B Preferred Shares, at their current annual fixed rate and will not transition to a floating reference rate.

Source: Business Wire

We give you our thoughts on this move. Keep in mind that this is not a "legal opinion", and no one in our team is a lawyer.

1) The Cost Savings From This Move, If Successful, Will Be Rather Small

PMT.PR.A has 4.6 million shares outstanding with a $115 million par market value. To calculate savings over the long term, you have to have a view of where short term rates would be in relation to PMT's longer term financing choices. But even in the most lop-sided of views, the savings are not huge. If we assume that 3-month SOFR would be about 5.5 %, then PMT would pay about 11.33% (float is at LIBOR plus 5.831%) versus the 8.125% fixed. So there you have a 3.2% savings on $115 million. PMT.PR.B is a larger issue ($175 million par value) and has a larger spread to LIBOR (5.99%). So savings here would be more. All said, we are looking at a 3.3% annualized run-rate on $290 million or about $9.5 million a year. Now, this is the start run-rate and the savings will be influenced by where shorter term rates go. It is also important to consider that if PMT was forced to pay this rate, would they?

After, all, they could redeem the issue and do so by either a) issuing a new fixed rate preferred share, b) dialing up leverage c) issuing common equity d) a combination of a), b) and c). So realistically their savings on this are small compared to their next best alternatives.

2) Lawsuits Are Highly Probable And Will Cost More

The LIBOR act which was signed into law in 2022 has some pretty clear cut references to what should be the replacement rate and it seems to be SOFR. In fact, let us show you a picture below from a 10-Q where transition happened on July 1, 2023 and you can guess which company this comes from.

No this is not PMT talking about its liabilities, but it is pretty darn close to home. The company is PennyMac Financial Services, Inc. ( PFSI ).

So PFSI switched to SOFR but PMT will stick to the old fixed rate. Got it. So lawsuits are a given and will cost the company a good chunk of change.

3) Goodwill Damage Will Likely Cost More

Any time you pull something like this on investors and whether or not it turns out to hold or not, you damage goodwill. We are not talking that balance sheet item which every company that buys another at an exorbitant price records. We are talking about real feelings that investors hold towards a company's debt and equity. This move has thrown it out. You can bet that the next time PMT comes to the market, investors are likely to demand more to hold a security from this company.

Verdict

Prior to this move, we did like PMT as a relative bet amongst the mortgage REITs. Granted that we view mortgage REITs as a whole as destroyers of capital, but just look at the relative tangible book value lost between PMT, Annaly Capital Management, Inc. ( NLY ), AGNC Investment Corp. ( AGNC ) and Dynex Capital, Inc. ( DX ).

PMT is a clear stand out. If you look at total returns, again PMT stands out and by a huge margin.

But the move here destroys any residual warm fuzzies we had. We rate the common shares a hold.

On the preferred front, again, with the current move, one is better off going to other companies with similar yields that have not tried such a move. If you had to pick up either PMT.PR.B and PMT.PR.A, we would wait until you get at least a 10% drop from Friday's close. We are halfway there based on pre-market trading.

Some might argue that we need a fixed yield identical to PMT.PR.C to buy PMT.PR.A and PMT.PR.B. That stance has some logic and certainly that would be an excellent entry point. However, you have to weigh the odds here. For us, there is a 90% chance this move does not hold up. So you have to weigh the potential upside on reversal, vs the downside catch-down to PMT.PR.C. We might make a shorter term speculative move if things align, but at present we are staying out. Keep in mind that you can get 8.7% yield to maturity even from PFSI bonds maturing in February 2029. So 10% plus from preferred shares should be par for the course here.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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