Weekly Series: mREIT And BDC Recommendations (And Price Targets) As Of 10/01/2023
We aim to retain the same layout from week to week. The layout is carried over from last week.
Weekly Notes From CWMF
Positions: No trades over the last week. Before that, I added to our CIM-B and CIM-D positions on 9/22/2023.
Commentary: I’m considering adding a bit more to shares that might float soon. However, it is the start of the month. That’s mostly relevant because sometimes the index funds (ETFs / mutual funds) need to purchase shares at the end of the month. That can cause a bump in prices right at the end of the month. So investors should be wary about using the 1-day price change to evaluate which shares seem like they are suddenly weaker. They may simply be unwinding part of the month-end gain.
I’ll be a bit wary with other investments. On the other hand, prices for these shares haven’t exactly fallen off. That’s significantly different from the other REIT index ETFs, where prices were pummeled. What’s providing support for the shares? I see the upcoming float dates as a huge factor. For better or worse, yield is a huge factor in pricing these shares. That is particularly true since Treasury yields began ripping higher so long ago.
I may still make a few opportunistic buys in other sectors to take advantage of weakness. However, I’ll still have a clear preference for buying fixed-to-floating shares that have upcoming dates (18 months or less) for floating. In that regard, the rally at the very end of the month (last two days) was a bit challenging.
Looking at the common shares in mortgage REITs, the week sent prices plunging. Part of that plunge is ex-dividend dates, which are big enough to swing prices. However, prices moved materially regardless. Perhaps the more impressive thing is that book values dipped even more.
I’ll sum it up briefly: “Rates up. Volatility up. Bad. Prices down. BV down.” There’s your 9-word summary.
Looking at some of the non-agency REITs trading at such discounts to BV, I’m surprised we don’t see some just announcing a strategy change to agency. Sure, agency BV’s have been getting crushed. However, the big spreads between MBS rates and Treasury rates are driving much higher price-to-book ratios for the agency mortgage REITs.
The logic goes like this: “If interest rates stabilize, BV would go up and net interest income would be great.”
The downside is that price-to-book ratios are still pretty high and there’s still a significant chance that volatility continues.
To be clear, volatility is bad (particularly for agency mREITs). If rates plunge to 2% or rip up to 6.5%, either one is really bad.
On a separate topic, there will be a net lease update soon. Targets will be adjusted downwards. WPC’s targets will be adjusted down more than other net lease REITs because of their poor plan to spin assets and destroy their dividend aristocrat status. As I run through other equity REIT targets, there will probably be several moderate negative revisions. The primary factor in each case is the recent run in Treasury rates and TIPS rates. Rates moving materially higher over the last month is creating more fundamental pressure. This will be covered in more depth in upcoming articles as the topic is too large to cover in my commentary section.
Weekly Notes From Scott
Positions: As noted in chat during the week, I increased my RITM and RC positions. Compared to my existing positions, both purchases were small.
BDC Weekly Change: NAVs relatively unchanged - slightly decreased. Spreads slightly widened.
Other Comments: Unlike the prior 6 weeks, a bit more volatility in high yield/speculative-grade debt but nothing alarming. This was “in-line” with general market sentiment/performance during the week. Correctly assumed either a “last minute” government shutdown solution (albeit only 45 days) or a very short-lived government shutdown (under 1 week). The 1st scenario prevailed over the weekend.
Underlying Portfolio Company Credit Changes Held by BDCs (Weekly): 1 downgrade (multiple BDCs impacted but already anticipated; CSWC, MAIN, PLFT, PSEC), 0 upgrades
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.
ARCC: 1 Up, (2) Down
CSWC: (2) Down
FSK: 1 Up, (1) Down
MAIN: 1 Up, (2) Down
OCSL: (1) Down
PFLT: 1 Up (JV Portfolio Company), (1) Down (Includes JV Portfolio Company)
PSEC: 3 Up (Includes 1 Restructuring), (3) Down (Including 1 Bankruptcy)
GBDC: (1) Down
SLRC: (1) Down
TCPC: 1 Up
OBDC: 1 Up, (1) Down (JV Portfolio Company)
TPVG: (1) Down (Declared Bankruptcy)
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
OBDC: (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. - Continuing the June - September 2023 trend, the market remains “cautiously optimistic” on high yield debt/speculative-grade credit. Spreads remain resilient as the market continues to “grapple” between plateauing short-term interest rates and economic uncertainty (typically impacting the longer-end of the yield curve). Still expect an eventual mild recession to pressure NAVs late 2023 - 2024. Factored into price-to-book targets. Spreads will likely widen beginning in fall 2023. Still tight relative to history. Due to TCPC’s announced merger with BKCC, along with a (2.5%) base management free reduction (which positively impacts future operating performance/net investment income [NII]), this BDC received a 5.5% percentage recommendation range upgrade in early September 2023. Continuing to watch the broader/macroeconomic impacts from the upcoming end of the 3-year student loan repayment pause (due to COVID-19) in October (and any new updates regarding this event).
MREIT Weekly Change: BVs continued their negative momentum from the prior 3 weeks and decreased. In fact, a very volatile week for agency MBS spreads. All BV decreases were notable (from a weekly perspective) for the agencies and less severe for the other 3 sub-sectors (hybrids, originator + servicers, and commercial whole loans).
Other comments: Even with stock price decreases across the agency mREIT sub-sector, in some cases projected BV declines were even more severe. As such, NLY and ORC were downgraded to a SELL/overvalued. With similar stock price declines but projected less severe BV declines, EFC, NYMT, and ACRE were upgraded based on valuation (see the accompanying tables for details). All agency MBS coupons experienced modest - notable price decreases (including all specified pools; mainly HARP and LLB loans). Most (short) derivative instrument valuations only slightly increased. Simply put, the vast majority of spread relationships I/we track (over 100 combinations) modestly - notably widened. Spread/Basis widening has now passed October 2022 levels (negative catalyst/trend). That said, I anticipate this level of widening to be a short-term event. Spreads should tighten somewhat heading into 2024.
View: Same as last week. Repo financing was, once again, relatively unchanged during the week (markets correctly anticipated an unchanged Fed Funds Rate at the September 2023 meeting). Agency mREIT sub-sector valuations remain unattractive (continue to wait for a better opportunity to initiate/increase one’s position). Simply put, the market continues to be a bit “ahead of itself” regarding agency mREIT valuations. A perfect example of this was the sell-off the past 2 weeks which we correctly warned subscribers beforehand (regarding this sub-sector being overvalued prior to this recent sell-off; in particular AGNC). Most agency mREITs likely remain in common share issuance mode (rebuild capital as MBS pricing remains historically attractive). This is especially the case within the agency mREIT sub-sector. MSR valuations have likely recently peaked but remain elevated versus historical trends. I/We do not anticipate a notable drop in MSR valuations over the foreseeable future (especially within lower coupons). The rate of financing cost acceleration has slowed over the past several months (which was previously correctly anticipated). Repo financing rates should peak in late 2023. Agency net interest spreads (excluding current period hedging income) are slightly - modestly negative. However, dependent on the utilization of interest rate payer swaps, adjusted net interest spreads remain acceptable for most peers (though will continue to slightly - modestly decrease over the next couple quarters). Net interest spreads will continue moving lower during the second half of 2023 and will likely “bottom out” close to year-end. Then, a slow, gradual increase will likely begin in the first half of 2024.
There will continue to be pressure in commercial whole loan pricing/valuations, especially in office loans. Simply put, continued credit/recession risk. However, there continues to be a bright spot for industrial loans (especially with the notion of a possible “soft landing” for the economy as a whole). 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. This included updated modeling in late June 2023 of all 3 sub-sector peer’s peak non-accrual rate this credit cycle towards the high end of my/our previous range. This negatively impacted per share recommendation ranges a bit back in late June 2023. ACRE, BXMT, and GPMT 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 notion was only solidified after fully analyzing BXMT’s Q2 2023 earnings results in late July 2023. This should be followed by ACRE and then GPMT. While GPMT should be trading at a discount to estimated CURRENT BV, I continue to believe the level of discount the market is pricing in is excessive (thus keeping GPMT very attractively valued). Just know GPMT is assigned a risk rating of 5 (very high risk; potential for very high reward) and it will take time to see this valuation strategy play out (very likely 1+ year out).
As anticipated, RC recently announced a quarterly dividend reduction from $0.40 per common share to $0.36 per common share. Simply put, no surprise. This reduction was within my/our $0.35 - $0.40 per common share projection (much higher probability was assigned to a cut to $0.35 per common share versus an unchanged $0.40 per common share dividend). After my dividend projection was provided several months ago, management recently "hinted" there would be a cut (again, within my previously-projected range). No change in RC’s percentage recommendation ranges or risk rating from this declaration. Simply put, this dividend reduction was already "baked" into RC recommendation ranges in conjunction with the announced BRMK merger months back. I continue to anticipate a RC dividend at or above $0.35 per common share over the foreseeable future (through, at a minimum, Q2 2024). After a projected RC core earnings “dip” for Q3 2023 (mainly due to non-utilized capital obtained via the BRMK merger), I anticipate an increase heading into 2024 to support the dividend (as capital is deployed).
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. Refer to those articles for company-specific details.
NOTE: This article is usually published Sunday evening or Monday morning. Sometimes it takes a bit longer.
The updates below were live in the spreadsheets by Sunday night, so the delay is just in preparing and posting this article.
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