Summary
- Chimera Investment Corp. Q2 results, while bad for the common stock, are great for the preferreds.
- Our value-based analytic perspectives bring new light to these often misunderstood securities.
- We recommend two preferred issues with the best opportunity to lock high yield income with capital upside.
Thesis
Chimera Investment Corp. ( CIM ) has suffered with the rest of the residential mortgage Real Estate Investment Trust (REIT) sector as its common stock (closely tied to the tangible book value of the assets) has declined. This always happens when interest rates meaningfully spike upward because fixed rate mortgage capital values are inversely related to interest rate movements.
Let's oversimplify the situation to illustrate how rising interest rates pressure mortgage values: If I am holding a fixed rate mortgage and the interest rate rises, investors will demand a higher rate from the mortgage I am holding. I cannot change the interest rate on a fixed-rate 30-year mortgage, so I have to lower the price I am willing to accept until investors get the yield they demand. The longer the time remaining on the mortgage, the deeper the discount I have to offer and that can get scary. The reality is less scary but far more complicated by the derivatives used to hedge against interest rate rises.
The preferred stocks, however, are more closely tied to current interest rate yields and the equity cushion under them. These have fared far better by comparison:
Ticker | Issue Type | YTD Performance |
CIM | Common | -46.41% |
CIM.PA | Series A | -13.75% |
CIM.PB | Series B | -14.98% |
CIM.PC | Series C | -18.77% |
CIM.PD | Series D | -16.70% |
Source: SA
With short term interest rates expected to rise above 4% next year based on the Fed's latest discussions , we further believe rates will float above core inflation as it comes down. That's continued bad news for the common, but is it bad for the preferred stocks?
We look at all four of CIM's preferreds, three of which convert to a floating rate over the next three years. Two of these represent compelling values today based on equity cushion coverage, cash flow dividend coverage and the discount to par. That discount allows us to lock in inflation fighting current yields with capital upside in case these are called at par ($25 per share). If they float, we project higher dividends, assuming short term rates remain at 3.5% or higher.
Background
Chimera is a residential mortgage REIT primarily holding single family mortgages (both agency and non-agency) as well as some agency commercial mortgages as an internally managed REIT.
The common stock has had a rough ride since its 2007 debut. Even looking at the 10-year bull market, the common (like most residential MREITs) does not give good returns for a passive buy and hold strategy. It's fairly well-known within the securitized mortgage market that a full interest rate cycle is basically neutral for the underlying common stocks. I learned this from my mortgages professor, Richard Roll. He set up Goldman Sachs mortgage research department in the 1980's and is one tough cookie when it comes to value.
Instead, we are hunting among Chimera's 4 series of preferred stocks for value:
Preferred Issue | Annual Dividend | Current Price | Current Yield | Call/ Floating Date | Floating Index | Index Today | Float Margin over Index | Current Floating Yield |
CIM.PA | $2.00 | $23.25 | 8.83% | 4/19/22 | N/A | N/A | N/A | N/A |
CIM.PB | $2.00 | $22.57 | 8.86% | 3/30/24 | LIBOR* | 3.07% | 5.517% | 9.51% |
CIM.PC | $1.9375 | $21.18 | 9.15% | 9/30/25 | LIBOR* | 3.07% | 4.617% | 9.07% |
CIM.PD | $2.00 | $22.14 | 9.03% | 3/30/24 | LIBOR* | 3.07% | 5.117% | 9.24% |
Source: EDGAR and Seeking Alpha
*We believe these stocks are converting from 3-month LIBOR to 3-Month Term SOFR +26.2 basis points as published by the CME . We have been tracking 3-month SOFR since June and the two have remained closer than 26.2 basis points (see below), which means we might experience an additional yield pick-up when the indices convert.
3-Month LIBOR v. 3-Month Term SOFR Spread
|
Source: CME and Global-Rates.com
Preferreds Under the Hood
We look at several measures to assess risk:
- Multiple of Common Stock (at current market cap.) to Preferred Stocks at par for capital safety coverage;
- Multiple of Distributable Earnings to Preferred Stock dividends for cash flow safety coverage; and
- Discount/(Premium) to Par price.
In additional to these measures, we look at contextual issues, too:
- REIT Rules
- Interest Rate Environment;
- Housing Market for:
- Construction;
- Existing and New Home Sales;
- Housing Prices; and
- Mortgage Default Rates.
Market Context
REIT Rules
REIT rules are very helpful for these preferred stocks, all of which carry cumulative dividend obligations. When assessing risk, knowing whether the issuer can skip or defer a preferred dividend is critical. REIT rules require every REIT to distribute 90% of net income each year as per the SEC and the IRS:
To qualify as a REIT, a company must have the bulk of its assets and income connected to real estate investment and must distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends.
That means as long as the REIT produces quarterly Distributable Earnings we get paid. No bank preferred stocks offer this feature. Heck, most bank preferreds offer only non-cumulative dividends.
Why compare to bank preferreds? MREITs are just specialty lenders without the same banking capital requirements or tax treatment. They are more like stripped-down savings & loan institutions than operating real estate businesses.
Interest Rates and The Fed
Unless you are hiding under a rock, we all see interest rates rising across the board and, according to Fed Chairman Jerome Powell last week, price stability (or low inflation) is job one. That implies rates rising through the balance of this year and into 2023.
Further, we believe the Fed is seizing this opportunity to return real interest rates (short term rates above the inflation rate) given the strong employment market and the need to restock a critical monetary policy tool that has been empty for 20 years. Thus, we forecast Fed Funds Rate at 3.5 - 4.0% in 2023 and beyond with any subsequent Fed rate reduction tied to core inflation dipping below 3%.
The Housing Market
The housing market is experiencing a mix of signals we view as positive for mortgage REIT cash flows, but not capital values:
- Low construction rates due to fear from the 2008 Great Recession, rising interest rates and rising labor costs slammed into rising demand from first time buyers to keep housing inventory very tight;
- New home sales have been far smaller part of the market;
- Existing home sales have materially declined from last year;
- Housing prices are rising at a much slower rate (about 10% versus 20+% in 2021);
- Goldman Sachs predicted this month that housing prices will be neutral next year; and
- Mortgage defaults continue to run low due to high employment and high equity under the overall mortgage market.
We are in an environment that lends itself to people staying in their existing homes and paying their mortgages to protect their equity. Additionally, defaults carry far higher residual equity values than 2008-2009 leading to profits from Real Estate Owned defaults for most MREITs forced to foreclose.
Even if we enter a recession where employment levels fall several percentage points (that would take a fairly deep recession), we do not forecast huge risk to residential single family mortgages. It will take a 2008-style liquidity/banking crisis to take down existing mortgage pools in any meaningful way with respect to default driven losses - an unlikely event from 2023 forward in our view.
While we see the context as very unfavorable to MREIT common stocks, we see very favorable tailwinds for the preferreds.
Preferred Safety Measures
Let's look at CIM's Q2 press release highlights :
2ND QUARTER GAAP NET LOSS OF $0.76 PER DILUTED COMMON SHARE
2ND QUARTER EARNINGS AVAILABLE FOR DISTRIBUTION (1) OF $0.31 PER DILUTED COMMON SHARE.
GAAP BOOK VALUE OF $8.82 PER COMMON SHARE
Chimera experienced book value shrinkage from the net loss, but produced Distributable Earnings far in excess of its preferred stock dividend obligations (Distributable Earnings is measured after expenses like the preferred dividends payable). In fact, the 4 Chimera preferred stock series dividends together are covered slightly more than 7 times by CIM's trailing twelve months Distributable Earnings (Source: Koyfin and SA).
That's a lot of safety margin when you consider banks lend high yield debt at 3 times interest coverage. Of course, preferred stock is not debt and debtholders have more rights. But, let's also not lose sight of the information in this measure - our REIT produces lots of Distributable Earnings as long as defaults are not rising significantly. Because CIM has to pay out 90% of that, we have a really well-covered investment whose cash flows have to come to us for tax reasons. That's motivation plus the ability to pay - magic!
How about the equity coverage, or how much cushion is under these preferreds? Would you believe more than 6 times common equity (at current market cap) than preferred stock coverage (Source: Koyfin and SA)? That's a lot of safety even as rates continue to rise another 1.5 to 2 percentage points.
Finally, all of these preferreds are trading at a discount from their par price of $25 per share, which gives us upside to the call price of $25 per share.
Although each preferred is relatively attractive, we prefer the series B & D for the following reasons:
- The Series A never floats, thus its price will tend to reflect the current interest rate environment tethered by a continuing call threat at $25 per share. Not much play here.
- We do see this preferred as our "canary in the coal mine" for call risk because CIM will likely call it first when it's in their economic interest;
- The Series C not only carries the lowest margin over LIBOR at 4.617%, it also converts a year later than the Series B & D. We get longer time duration exposure to rising interest rates with a lower credit margin when it converts - yuck! Even the higher 20 bps current yield doesn't tip the scales for us.
The Series B & D both convert on the same day in 2024, but the Series B will float at 0.40% (or 40 bps) higher and it is $.40 more expensive (or 1.6% higher) today.
The Series B will pay out an additional $0.67 per share over the next 20 months until conversion, which at a 5% discount rate is worth about $.44 per share today.
Conclusions
Residential MREIT fixed-to floating preferreds are among the best cash flow asset classes today in high yield fixed income when you consider one simple feature - they have to pay the dividend to keep their tax status!
Neither the Series A or C is attractive relative to CIM's Series B & D offerings today.
The Series B & D, although at differing prices and margins over LIBOR upon conversion, are essentially equivalent values today and represent strong buys with approximately 9% current yields.
Important Trading Note: MREIT Preferreds are relatively illiquid. Always buy with Limit Orders and patience.
For further details see:
Chimera Preferreds Offer Value; The Common Does Not