SCCD - Sell The Sachem Preferred Stock And Buy Sachem Bonds

2023-03-24 12:00:00 ET

Summary

• SACH has several high yielding baby bonds with yields to maturity in the 12.5% range.
• On the other hand, the more risky Sachem preferred stock (SACH.PA) currently sells at a higher price than the SACH baby bonds with a much lower current yield of 9.1%.
• Thus, there is no reason to own SACH.PA when the company’s bonds offer greater price upside, a better yield and more safety.

Introduction

At our Conservative Income Portfolio service, we have a strong focus on finding relatively and objectively undervalued and overvalued securities to generate returns that beat the market benchmarks. This research also lends itself to pair trades (long/short) which allow subscribers to make money while avoiding market risk in this tumultuous market. We also focus on special situations which also avoid market risk as in this article .

Today we focus on Sachem Capital ( SACH ) and the gross mispricing between their baby bonds and their preferred stock. If you are an owner of the preferred stock (SACH.PA), we strongly recommend that you take advantage of its current overpricing and sell it. The baby bonds are definitely a better place to have your money invested.

Sachem Capital

Sachem Capital Corporation is a mortgage REIT (mREIT) that makes both residential and commercial loans. As is typical of mREITs, its goal is to provide a high level of dividends to its shareholders. Here is how the company describes its business:

Our business objective is to protect and preserve invested capital in a manner that provides for attractive risk-adjusted returns to our shareholders over the long term principally through dividends. We intend to achieve this objective by continuing to focus exclusively on selectively originating, servicing and managing a portfolio of short-term (i.e., one to three years) real estate loans secured by first mortgages on real estate located primarily in Connecticut as well as Florida, Massachusetts and New York. Our portfolio is designed to generate attractive risk-adjusted returns across a variety of market conditions and economic cycles. We believe that our ability to react quickly to the needs of borrowers, flexibility in terms of structuring loans to meet the needs of borrowers, intimate knowledge of the real estate markets that we serve, expertise in “hard money” lending and our focus on newly originated first mortgage loans, should enable us to achieve this objective. Nevertheless, we will remain flexible in order to take advantage of other real estate related opportunities that may arise from time to time, whether they relate to the mortgage market or to direct or indirect investments in real estate.

One thing to note is that their mortgage loans are 1 to 3 years in length. Thus, they are not locking in rates for a long period and are less susceptible to seeing a drop in the value of their loans like other mREITs. Their loans are generally to owners of residential property who are interested in fixing up properties in order to sell them at a profit. They also now lend to commercial property owners who are looking for money to upgrade their properties.

Safety

SACH is a very conservative lender.

1. They only make first lien mortgages and target a 70% maximum loan to value on their loans. In other words, the property would have to drop in value more than 30% in a relatively short period of time for SACH to possibly take a hit on a loan.
2. Their loans are made at very high yields and they require hefty upfront fees from their borrowers.
3. If the company has any reservations about a borrower, they may also require a personal guarantee from the borrower as well as possibly requiring the borrower to put up other collateral as insurance as well as the property that the mortgage will cover.
4. The company operates at much lower leverage than typical mREITs. Commercial mREITs tend to have leverage around 80% and residential mREITs often have leverage up to 90%. SACH, as of their 3 ^rd quarter of 2022, had leverage of under 50% when taking liabilities net of cash versus assets.
5. Needham just provided SACH with a revolving line of credit showing at least some confidence in the company.

SACH Preferred Stock Versus Its Baby Bonds

Below is a chart of the 4 longest term SACH baby bonds versus SACH-A preferred stock.

As you can see there is a huge mispricing between the SACH baby bonds and the preferred stock with the baby bonds having a YTM of up to 12.8% on the 2026 bond while the preferred stock has a current yield of only 9.1%.

Although not shown here, SCCG even has a current yield of 9.4% which is higher than SACH-A’s current yield and that doesn’t count the fact that SCCG will pay off at $25.00 at maturity assuming no bankruptcy. Who knows where the preferred stock might be trading. SACH-A could well be trading lower as it traded as low as $18.07 about 4 months ago. So while SACH-A trades more than $3.00 above its low, SCCE for example, trades at less than $1.00 above its low.

So the price risk on SACH-A is much greater than the risk on the price of the baby bonds. In fact, I would be very surprised if SACH-A does not move lower in price.

While the interest on bonds must be paid or the company winds up in bankruptcy, the preferred stock can have its dividend suspended if the company finds itself with liquidity or operational problems. And even in a bankruptcy, the baby bonds are likely to receive some recovery as the baby bonds make up most of SACH’s debt. The preferred stock very likely gets zero in a bankruptcy, and if they do get something it will certainly be far less than the baby bondholders will get should this scenario come to pass.

Normal Pricing of Preferred Stocks Versus Baby Bonds

With SACH, we see the YTMs on the baby bonds being much higher than the current yield on the preferred stock. This is highly unusual. Here are a few examples of normal pricing.

Preferred Symbol Current Yield Bond YTM

ESGRO 7.85% June 2029 Bond 6.1%

FTAIN 9.83% May 2028 Bond 8.1%

TRTN-B 8.47% March 2032 Bond 6.4%

So in the above cases, you see that bonds tend to trade with YTMs that are 1.5% to 2.0% lower than the current yield on preferred stocks from the same company. But in the case of SACH, the bonds are actually trading 3.5% higher YTM than the preferred stock current yield. In the case of FTAIN, the current yield of SACH-A is actually lower than the current yield of FTAIN yet the SACH baby bonds are trading at a YTM that is more than 4% higher than the YTM on the FTAI bond.

So either the SACH baby bonds are a screaming buy relative to SACH-A, or SACH-A is a screaming sell relative to the SACH baby bonds. Or possibly the truth is somewhere in the middle.

Relative Fair Value

I believe that SACH-A is about $3.00 per share overvalued relative to the SACH baby bonds , or that the SACH baby bonds are quite undervalued relative to SACH-A. So let’s assume that SCCF is $1.00 higher than its current price which would be $21.54. And let’s assume that SACH-A is $2.00 lower than its current price which would put its price at $19.34. At these prices, SCCF is still a much better value with a YTM of 11.2% versus a current yield on SACH-A of 10.13%. So the mispricing here is enormous.

Conclusion

Currently SACH-A preferred stock is trading at a current yield of 9.1% while SACH baby bonds have yields to maturity above 12.5%. This is a massive mispricing when you can get such a higher yield from the bond than you get from the preferred stock. Even if SACH-A dropped $2.00 and SCCF rose by $1.00, SACH-A would still be overvalued relative to SCCF.

Additionally, the bonds trade at a larger discount to par than SACH-A and thus have more price upside as well as naturally having more safety as well.

Thus, I strongly recommend that you sell SACH-A and redeploy the money in SACH baby bonds or find another undervalued security in which to invest the money you will receive from the sale. Personally, I like the SACH baby bonds as this company is a conservatively run mREIT with a good balance sheet and the bonds have the protection of not only the common stock, which pays a high dividend, but also of the SACH-A preferred stock. The SACH bond yields look to me to be very high relative to the risk.

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