Weekly Series: mREIT And BDC Recommendations (And Price Targets) As Of 07/07/2023, Includes Q2 2023 Earnings Projections

Hi subscribers.

Welcome to our first Weekly Series post through our own website!

Within the “New Commentary and Images” section, you’ll find brief summaries of what happened for fundamentals over the last week. Then you’ll find charts and tables covering all the major developments.

This article is a joint effort between CWMF and Scott Kennedy.

Who Does What?

Scott provides full coverage for:

• 20 Mortgage REIT common stocks

• 15 BDC common stocks

For each stock that includes:

• Research and data

• Modeling projected book values / net asset values (BV/NAV)

• Setting common stock recommendation ranges (targets / ratings)

• Answering a few questions on the stocks

Colorado (“CO” / “CWMF”) Wealth Management Fund provides coverage on:

• Equity REIT common stocks

• Mortgage REIT preferred stocks

• Introductory articles for relevant concepts

• Macroeconomic trends

Layout

The rest of this article is split into two major categories:

1. New commentary & images for this week. (Pretty fast)

2. Repeated sections (linked for the moment, as we revise the method for including them).

You’ll know you’ve hit the repeated section. It has a pretty obvious image. With that said. Let’s get into the article.

New Commentary and Images Begin

A Few Notes from Scott:

Positions: No new or sold positions.

BDC Weekly Change: NAVs relatively unchanged - slight increase. Spreads slightly tightened.

Other Comments: Market remains “cautiously optimistic” on high yield debt/speculative-grade credit. Spreads remain resilient.

Underlying Portfolio Company Credit Changes Held by BDCs (Weekly): 2 upgrades (MAIN + PSEC; different portfolio companies) and 0 downgrades.

Underlying Portfolio Company Credit Changes Held by BDCs (Current Quarter-to-Date):

This is a running tally of the credit upgrades and downgrades for companies held by each BDC.

• MAIN: 1 Up

• PSEC: 1 Up

Underlying Portfolio Company Credit Changes Held by BDCs (Prior Quarter):

This is a running tally of the credit upgrades and downgrades for companies held by each BDC.

• ARCC: 2 Up (1 Solely Unfunded Commitment), (2) Down

• CSWC: 1 Up, (1) Down

• FSK: (2) Down (1 Portfolio Company Double Downgrade + Declared Bankruptcy)

• MAIN 1 Up, (1) Down

• OCSL: (1) Down

• ORCC: (4) Down, 1 Up

• SLRC: (1) Down

• PFLT: (1) Down

• PSEC: (4) Down (Already Anticipated Hence Our Prior Recommendation Range and Risk Rating Downgrade Back in May; Prior To The Actual Credit Downgrades)

• TCPC: (1) Down

• TPVG: 3 Declared Bankruptcies

View: Same as last week. - Still expect an eventual mild recession to pressure NAVs late 2023 - early 2024. Factored into price-to-book targets. Spreads will likely widen beginning in late summer - early fall 2023. Still tight relative to history.

MREIT Weekly Change: Most BVs continued to move slightly - modestly lower. Those most impacted were mREITs with lower-coupon agency MBS and derivative instruments with a shorter tenor-maturity.

Other comments: Once again, agency mREITs, as a whole, experienced the largest weekly BV decreases (percentage-wise). Agency MBS pricing was negative for all coupons. Derivative instrument valuations were positive but couldn’t match agency MBS pricing decreases. Similar trend as last week. Most hybrid, originator + servicer, and commercial whole loan mREITs experienced slightly decreasing BVs (again, similar to last week). Repo financing crept higher during the week which makes sense with overall rates/yields pushing higher (and the likely Fed Funds Rate hike later this month).

View: Same as last week. - Agency net interest spreads are still extremely narrow (if not slightly negative). However, dependent on the utilization of interest rate payer swaps, adjusted net interest spreads remain attractive/acceptable for most peers. Repo financing will likely move a bit higher during 2023. Net interest spreads will continue moving lower during the second half of 2023 and will likely “bottom out” towards year-end. Then, a slow, gradual increase will likely begin in early 2024.

Continued pressure in commercial whole loan pricing/valuations, especially in office loans. Continued credit/recession risk. A bright spot for industrial loans. Could even throw hospitality and retail loans in that mix (certainly better than the COVID-19 trends) but isolated credit events will occur in these sub-sector as well.

As noted last week, with continued pricing pressure on office valuations, I/we made the prudent decision to slightly lower the commercial whole loan mREIT’s percentage recommendation ranges heading into Q3 2023. This included updated modeling of all 3 sub-sector peer’s peak non-accrual rate this credit cycle towards the high end of my/our previous range. As such, with all sub-sector peers having office exposure, ACRE, BXMT, and GPMT received a (2.5%) recommendation range downgrade (relative to estimated CURRENT BV).

This negatively impacted per-share recommendation ranges a bit in late June 2023. However, these percentage recommendation range downgrades did not result in any risk rating downgrades. ACRE, BXMT, and GPMT still have a risk rating of 4, 3.5, and 5, respectively. Each peer will continue to have heightened monitoring regarding asset/loan resolution within the office sub-sector and all other troubled loans.

As the risk ratings indicate, BXMT should come out of this credit cycle the least harmed out of the 3 covered sub-sector peers. This should be followed by ACRE and then GPMT. At GPMT’s level of discount to estimated CURRENT BV, subscribers should be eyeing/hoping for an eventual acquisition/merger by a 3rd party. Similar to AAIC, this will likely take some time (especially for this specific sub-sector) so subscribers have to be patient with GPMT’s prospects. As a reminder for subscribers, each company's earnings assessment article (linked in the tables deeper in this article) takes a deeper dive into a company's investments/sub-portfolio trends so that's really where more details will be provided.

A Few Notes from CWMF:

Positions:

On 7/03/2023, I closed our position in PMT-C.

As of 7/10/2023 (before finishing this article), I closed our position in DX (link to trade alert for premium members).

Commentary (written 7/10/2023):

This is the first weekly article of the second quarter. We often skip the series briefly while reviewing all the estimates for the quarter that just ended. I decided to include the weekly for the 6/30/2023 values along with the 07/07/2023 values. You’ll see the values for 6/30/2023 labeled as “skip week” and the date of NAV estimates is in a red box.

It’s particularly interesting for the mortgage REITs as we had 8 mortgage REITs rally into downgrades for 6/30/2023. While share prices were going up, only one mortgage REIT was projected to have flat BV (due to a pending buyout). The rest saw BV declining, yet the only mortgage REIT that ended June with a dip in the share price was NLY. On the other hand, every single mortgage REIT saw a hit to share prices in the first week of July.

ARMOUR Residential REIT (ARR) was particularly strange as the share price increased by 4.7% while the projected BV fell by 2.8%. This last week the values were moving together as ARR’s BV and share price both declined by about 3%.

Earnings Projections: 

One of the reasons for closing DX today was the projected miss for earnings. I went through Scott's projected earnings and compared them to the consensus estimates (as of the end of Q2 2023). It is possible for the consensus estimates to be "updated" before the REITs report, which could change the headline for "miss" or "beat".

• Notable Projected Misses: (DX), (TWO), (ORC)

• Moderate Projected Misses: (MFA), (MITT), (CIM)

• Notable Projected Beat: (IVR)

• Moderate Projected Beat: (BXMT), (ACRE), (GPMT)

• There are several other projected beats or misses; I'm just highlighting the more material ones.

We tend to care more about the BV performance, but the earnings can drive headlines and move share prices.

Projections for BDCs were all for much smaller deviations relative to consensus estimates. 

Note: If earnings are expected to be a fairly number, it only takes a few cents to create a projected beat. Example: GPMT has a consensus for $.146 and Scott's projection at $.170.

Second Note: It is not possible to nail to every projection. You can see prior articles to evaluate the accuracy of forecasts for prior quarters.

Breaking Down Concepts:

I’ll use the rest of my space to break down some of Scott’s commentary for readers.

How can spreads be both extremely narrow and remain attractive? It comes down to hedging.

If you were looking at buying a new MBS today that trades around face value (about $100 per $100.00 of face value), you would get a security a yield of about 5.5% for the 15-year or 6.0% for the 30-year. Because that security trades very close to $100.00, prepayments don’t change the yield. There is no premium to amortize. You don’t know how quickly borrowers will prepay (which can be a significant risk factor), but you know the yield.

However, many of the agency MBS that trade below face value will carry lower yields. Not just a lower coupon rate, they also carry a lower yield. Why is that? Because an MBS with a 3% coupon rate is vastly less likely to prepay. As the owner of that MBS, you can predict the prepayment rate much more effectively (it’s very low). Since you know prepayments will almost certainly be very low, you can be more precise with your hedges. That’s a nice advantage. Consequently, investors will accept a slightly lower yield on that security. Hypothetically, let’s say that one of those pools is projected to yield about 5.35%.

The spread over repo costs would be extremely narrow at best, or negative at worst.

But what happens when it gets hedged? If the hedge was locking in rates at 4% for 10 years, then the spread could be 1.35%. At that point, the hedged rate remains attractive. Therefore, the adjusted net interest spread would remain attractive.

What if you buy the 30-year MBS at a 6% coupon rate for just a tiny bit over $100? Could you hedge that with a 10-year derivative around 4%? You “could”, but the hedge and the asset wouldn’t match up very well. If rates fall, prepayments would go up. You would have to reinvest more of that cash at a lower yield. Consequently, that’s not a good match.

You could hedge by using some 3-year rates around 4.55% and 5-year rates around 4.25%, but that cuts into the net interest spread because you have a higher rate on the hedge.

Is there anything positive? Sure. The spread that is present after hedging is pretty good. That can be very nice, but we’re not getting big discounts to book value on the agency mortgage REITs. Ideally, we want those big spreads and we want a significant discount to book value.

Weekly Recommendations