2023-04-19 15:39:37 ET
Summary
- Chimera Investment Corporation is facing a challenging business environment, as short-term interest rates exceed long-term interest rates.
- The adverse environment has resulted from the aggressive interest rate hikes implemented by the Fed.
- However, interest rates are likely to peak in the next few months.
- Chimera Investment Corporation 8% PFD CUM SER D is offering a 10.0% dividend yield with a wide margin of safety.
When a stock offers an abnormally high dividend yield, it usually signals that a dividend cut may be just around the corner. However, the preferred stock of Chimera Investment Corporation (CIM), Chimera Investment Corporation 8% PFD CUM SER D ( CIM.PD ), is a bright exception to this rule. The company has repeatedly cut its common dividend over the last decade, and hence its common dividend is not safe, particularly given the high payout ratio of the common stock. On the contrary, the 10.0% preferred dividend has a wide margin of safety. In this article, I will discuss why income-oriented investors should consider purchasing the preferred stock of Chimera.
Business overview
Chimera is a real estate investment trust, or REIT, that invests in a diversified portfolio of mortgage assets, such as residential mortgage loans, non-agency residential mortgage-backed securities, agency mortgage-backed securities secured, agency mortgage-backed securities secured by pools of commercial mortgage loans, and other securities that are related to real estate.
Chimera borrows funds and pays interest that depends on short-term interest rates. The REIT then invests these funds on the above mentioned assets and thus it receives a yield that is determined by long-term interest rates. In other words, the earnings of the company are highly sensitive to the spread between long-term interest rates and short-term interest rates.
Since the Great Recession, interest rates remained depressed until last year. Chimera greatly benefited from this favorable environment, which resulted in minimal borrowing costs and a reliable spread between long-term and short-term interest rates. The company remained highly profitable during 2012-2021 and hence the common stock offered a generous dividend throughout this period.
Unfortunately, the coronavirus crisis and the Ukrainian crisis completely changed the business landscape for Chimera. The government resorted to unprecedented fiscal stimulus packages to offset the impact of the pandemic on the economy. In addition, the war in Ukraine and the resultant sanctions of the U.S. and Europe on Russia led commodity prices to skyrocket last year. As a result, inflation surged to a 40-year high last year.
Due to this development, the Fed has been raising interest rates at an unprecedented pace since early last year. The Fed has adopted this aggressive stance in order to cool the economy and restore inflation to its target level of about 2%. The steep increase in interest rates has formed a strong headwind for Chimera. Even worse, short-term interest rates have risen above long-term interest rates, thus signaling that a recession is likely to occur in the near future. This phenomenon is called an “inverted yield curve.”
As mentioned above, the earnings of Chimera depend on the spread between long-term and short-term interest rates. Unfortunately for the company, short-term rates have been higher than long-term rates in the last 12 months and thus they have been exerting great pressure on the margins of Chimera. This is clearly reflected in the below slide from the latest presentation of Chimera.
Due to the surge of short-term interest rates, Chimera saw its financing costs increase from 3.0% in the third quarter to 3.9% in the fourth quarter. Consequently, its net interest spread shrank sequentially from 2.6% to 1.6%. This trend is the key factor behind the 39% plunge of the earnings per share of the company, from $1.78 in 2021 to $1.08 in 2022.
Even worse, Chimera is likely to incur a further decline in its earnings this year due to the persistently adverse environment of interest rates. Analysts expect the company to incur another 32% decline in its earnings per share this year, from $1.08 to $0.73.
On the bright side, the Fed is likely to end its rate-hiking cycle within the next few months, as interest rates have already risen to exceptionally high levels. As interest rates are likely to peak in the upcoming months, the worse seems to be behind Chimera. Indeed, analysts expect the earnings per share of the company to partly recover in 2024, from $0.73 to $0.90.
It is also important to note that inflation has declined every single month since it peaked almost a year ago thanks to the aggressive policy of the Fed. If inflation remains on its downtrend, it will enable the central bank to begin lowering interest rates late this year or next year. Whenever interest rates normalize, they are likely to restore the profit margins of Chimera to normal levels.
Dividend
The preferred stock of Chimera is currently offering a 10.0% dividend yield. The exceptionally high yield of the preferred stock has resulted from the surge of interest rates as well as concerns of the market that the dividend is not entirely safe.
Chimera has cut its common dividend more than once throughout the last decade. The company has always maintained exceptionally high payout ratios in an effort to reward its common shareholders as much as possible. As a result, it has been forced to slash its common dividend in some occasions. Given the current payout ratio of 94% , it is evident that the common dividend is far from safe.
On the contrary, the dividend of the preferred stock of Chimera is much safer. First of all, the REIT does not have the right to cut its preferred dividend without eliminating its common dividend first. Chimera has exhibited volatile earnings and went through a severe downturn during the Great Recession, in 2009, but it never stopped offering a common dividend. As the Great Recession was the worst financial crisis and the worst downturn of the housing market of the last 90 years, it is evident that Chimera is not likely to eliminate its common dividend even under the most adverse business conditions. As long as the company does not eliminate its common dividend, the shareholders of the preferred stock should rest assured that the preferred dividend will remain intact.
It is also important to realize that the amount of preferred dividends paid by Chimera is extremely low when compared to the amount of common dividends. To be sure, the amount of preferred dividends ( $73.8 million ) paid over the last 12 months is just 20% of the total dividends ($361.5 million) paid by Chimera during this period. Moreover, the amount of preferred dividends is only 29% of the adjusted earnings of the company in the last 12 months and hence the company can easily continue paying its preferred dividends without any problem. To cut a long story short, the 10.0% dividend of the preferred stock of Chimera has a wide margin of safety.
Risk
As mentioned above, inflation has subsided every single month since it peaked almost a year ago. As a result, the Fed is likely to end its rate-hiking cycle within the next few months. However, if inflation stops declining and persists for much longer than currently anticipated, the Fed will probably have to raise interest rates much more than anticipated. In such a case, the depressed profit margins of Chimera will remain in place longer than currently expected and hence both its common stock and its preferred stock will probably come under pressure. Therefore, great patience may be needed in such an adverse scenario. Fortunately, the odds of many more interest rate hikes are low.
Another caveat is the volatility of the preferred stock of Chimera. Due to this volatility, the stock is suitable only for the investors who can wait patiently for the downturn to pass and remain focused on the attractive dividend yield.
Final Thoughts
I have always avoided the common stock of Chimera due to its volatile business performance. However, the preferred stock of Chimera is a completely different case. The preferred stock is currently offering a 10.0% dividend, which has a wide margin of safety. Therefore, it is a great candidate for the portfolios of income-oriented investors.
For further details see:
Preferred Stock Of Chimera Offers An Attractive 10.0% Dividend Yield