Weekly Series: mREIT And BDC Recommendations (And Price Targets) As Of 06/09/2024
Hi subscribers.
We aim to retain the same layout from week to week.
Weekly Notes From Colorado Wealth Management Fund
Positions: Closed out our position in CIM-D on Friday. I haven’t reallocated yet. I’m using a Treasury ETF (SHV) for the moment. I’ll be evaluating opportunities to redeploy.
When I provided our initial research note on CIMN (the new baby bond from Chimera Investment Corporation), about 10 days ago, I saw that as a potential place to redeploy. However, CIMN also performed quite well since our initial note. The price moved modestly. Since baby bonds tend to mature in 5 years or so from initial issuance, the share price moving a few percentage points can create a material shift in the yield to maturity and yield to call.
When we compare the yield to maturity against a Treasury on one hand against preferred shares on the other, we can create a range for the yield we should expect. That higher level of precision for expected yields leads to a much tighter range for baby bond valuations. I would still be interested in it if the price falls (or perhaps when there’s more dividend accrual or when Treasury rates are lower), but for the moment I’m okay sitting with my Treasury bill ETF for a little bit and just watching to see what happens.
Commentary: Rates were moving quite a bit lower on the week but surged on Friday. They closed the week only modestly lower.
Report in Americold (COLD) is nearly complete. That was a harder one. There will be some easier updates coming after that. Realty Income (O) placed well in reader polling, so it will have a bonus article.
Weekly Notes From Scott Kennedy
Positions: As noted to subscribers, I initiated a position in GBDC last Thursday. Decent valuation in the current environment for this BDC. At the time of purchase, GBDC was extremely close to the start of our UNDERVALUED/BUY range. In general, I am continuing to be patient regarding selectively deploying capital in attractively-valued stocks (especially within mREIT common stocks). Patience remains key as catalysts/events will take time to play out.
BDC Weekly Change: Spreads remained relatively unchanged.
BDC Other comments (Current Week): Once again, low volatility in high yield/speculative-grade debt this week.
Regarding weekly recommendation changes (mainly due to stock price and projected NAV changes), 0 upgrades and 1 downgrade occurred. FSK moved from APPROPRIATELY VALUED/HOLD to slightly OVERVALUED/SELL strictly based on valuation.
PART 2 of our BDC sector comparison article will be out 6/17/2024 - 6/18/2024 (PART 1 was provided in late May 2024).
Due to continued sector underperformance, along with no likely near-term future positive catalysts playing out (including no reduction in management fees), I have decided to drop PSEC coverage. PSEC will no longer be in the subscriber spreadsheets starting in July 2024. The process to pick up a new BDC stock has begun (will begin coverage on 7/1/2024). Subscribers recently voted in a SA chat thread regarding which BDC stock they would like to see coverage on. The top 3 choices were HTGC, BXSL, and TRIN. A new, final round BDC subscriber vote is currently ongoing in SA chat. Out of HTGC, BXSL, and TRIN, subscribers are currently voting on which 1 stock to add to coverage. This final round of voting will close on 6/13/2024. If no BDC stock receives at least 60% of the final vote tally, I will perform a “deep dive” analysis later this month to determine which BDC is currently the most attractively valued stock while also considering who has the highest probability of long-term sector outperformance. Once this determination is made, I will choose which BDC stock is added to coverage.
Calendar Q1 2024 Recommendation/Target Range + Risk/Performance Upgrades (Downgrades) (Running Tally):
Underlying Portfolio Company Credit Changes Held by BDCs (Weekly): 0 downgrades, 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 (Bolded Indicates Current Week Change).
ARCC: 1 Up (Very Large Investment), (4) Down (Large Investment*, Small Investment, Very Small Investment**, Large Investment***)
CSWC: (1) Down (Medium Investment)
FSK: 1 Up (Medium Equity Investment), (1) Down (Large Investment)
GBDC: (1) Down (Small Investment*)
MAIN: (1) Down (Medium Investment)
MFIC: (1) Down (Small Investment**)
OBDC: (2) Down (Very Large Investment***, Large Investment)
OCSL: 1 Up (Small Joint Venture Investment), (1) Down (Medium Joint Venture Investment [Both JVs]*)
PSEC: (2) Down (Large Investment, Large Investment**)
SLRC: 2 Up (Small Investment, Very Large Investment), (1) Down, (Small Investment*)
TCPC: 1 Up (Medium Investment), (2) Down (Medium Investment**, Medium Investment)
* = Regarding ARCC’s, GBDC’s, OCSL’s, and SLRC’s credit downgrade, this pertains to a portfolio company in the retail sector who is seeking Chapter 11 Bankruptcy protection. That said, this portfolio company was already “troubled” over the past year or so and this filing was previously anticipated (just a matter of exact timing). Out of the 4 BDCs impacted, ARCC has the largest exposure to this portfolio company but already marked-down the fair market value (“FMV”) of the company’s non-accrual loan by a considerable amount. That said, some additional losses/remaining mark-downs will likely occur during the calendar first and/or second quarter of 2024 which was already considered in our recent CURRENT NAV projections.
** = Regarding ARCC’s, MFIC’s, PSEC’s, and TCPC’s credit downgrade, this pertains to a portfolio company in the communications sector who had a restructuring due to continued operational weakness. This portfolio company was “troubled” over the past several quarters and this restructuring event was previously anticipated (just a matter of exact timing). Out of the 4 BDCs impacted, PSEC has the largest exposure to this portfolio company (by a considerable amount). PSEC and MFIC were fairly “aggressive” regarding each company’s 12/31/2023 fair market value (“FMV”) of this portfolio company. Some additional losses/mark-downs will likely occur during the calendar first and/or second quarter of 2024 which was already considered in our recent CURRENT NAV projections.
*** = Regarding ARCC’s and OBDC’s credit downgrade, this pertains to a portfolio company in the services sector who has been “troubled” over the past several quarters. ARCC already had the company’s 2nd lien debt investment on non-accrual status as of 3/31/2024 while OBDC did not have the company’s very large 2nd lien debt investment on non-accrual status as of 12/31/2023. I previously modeled/anticipated OBDC will put this debt investment on non-accrual status as of 3/31/2024. Additional losses/mark-downs will likely occur during Q2 2024 which was already considered in our recent CURRENT NAV projections.
BDC View (Same as last week): Continuing the June - May 2024 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 in late 2024 - 2025. This expectation is already factored into price-to-book targets. Spreads will likely begin widening during 2024. Still tight relative to history.
With the continued market rally, valuations within the BDC sector are remaining “pricey” in some names. I believe the majority of sector earnings are near their peak (plateauing). The rapid net investment income (“NII”) growth during 2022 - 2023 will not occur during 2024. As the FOMC eventually begins to reduce the Federal Funds Rate (likely later this year), sector earnings will GRADUALLY decrease over time. The severity of decreases will vary peer-to-peer (which I/we continuously project/model). This notion is already embedded in all price targets. That said, SLRC still has a bit of value (however, to remain non-bias, not nearly as good of a deal as most of 2023).
I will continue to monitor the recent developments in the Middle East (including all escalations/responses to a larger regional war) and broader macroeconomic impacts in the United States regarding private debt/credit markets.
mREIT Weekly Change: Most agency mREIT BVs slightly increased during the week. This was mainly due to agency MBS spreads slightly tightening versus underlying net (short) hedges. Most hybrid mREITs likely experienced a relatively unchanged - slightly decreasing BV while the commercial whole loan and originator + servicer mREITs likely experienced a slightly decreasing BV.
mREIT Other comments (Current Week): Regarding weekly recommendation changes (mainly due to stock price and projected BV changes), 0 upgrades and 1 downgrade occurred. ACRE moved from UNDERVALUED/BUY to APPROPRIATELY VALUED/HOLD strictly based on valuation.
Regarding weekly agency mREIT BV movements, most agency MBS coupons experienced minor - modest price increases (including a majority of specified pools; mainly HARP and LLB loans). Most (short) derivative instrument valuations slightly decreased. Simply put, the vast majority of spread relationships I/we track (over 100 combinations) slightly tightened.
PART 1 of our mREIT sector comparison article will be out 6/10/2024 - 6/11/2024. This includes updated non-accrual percentages.
Subscribers need to remain patient regarding catalysts playing out in the hybrid and commercial whole loan mREIT sub-sectors (longer-term horizon/mind set).
Calendar Q1 2024 Recommendation/Target Range + Risk/Performance Upgrades (Downgrades) (Running Tally):
mREIT View (Same as last week): 1) Agency mREIT Sub-Sector Trends: Valuations, as a whole, remain unattractive in most agency mREITs. As such, patience is key. While repurchase financing rates have likely peaked in late 2023, agency net interest spreads (excluding current period hedging income) remain slightly - modestly negative. However, dependent on the utilization of interest rate payer swaps, adjusted net interest spreads remain acceptable for most peers. A very slow, gradual increase in net spreads will likely begin during the first half of 2024 but this will be a “slow go”. Need to respect the “higher-for-longer” interest rate/yield environment.
2) Commercial Whole Loan Sub-Sector Trends: There will continue to be pressure in commercial whole loan pricing/valuations, especially in office and some isolated pockets of multifamily loans during 2024 - 2025. ACRE, BXMT, FBRT, and GPMT were a perfect example of this during Q3 2023 - Q1 2024 (new non-accrual and/or “watch list” 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 June 2023 - May 2024 of all 4 sub-sector peer’s peak non-accrual rate this credit cycle (above the high end of my/our previous range). These adjustments were to account for a quicker/more severe spike in credit risk (versus previous expectations) impacting my/our modeling (mainly impacting performance during late 2024 - 2025). This also factors in a higher probability of a “higher for longer” mentality regarding interest rates/yields. ACRE, BXMT, FBRT, and GPMT will continue to have heightened monitoring regarding asset/loan resolution within the office (and more recently multi-family) sub-sector and all other troubled loans. While GPMT should be trading at a notable 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 5.5 (extremely high risk; potential for very high reward) and it will take time to see this valuation strategy play out (very likely 1+ year out).
3) RITM’s Likely Proposed Spin-Off: I am still awaiting RITM SEC filings regarding the company’s “organizational changes” in relation to its proposed spin-off of its mortgage origination business (NewRez and affiliated subsidiaries) that could occur during 2024. That said, during RITM’s Q1 2024 earnings call, management now appears to be “cooling their jets”/delaying this spin-off over the foreseeable future. I am fine with this delay in the “higher-for-longer” interest rate/yield environment. Subscribers need to remain patient on this potential future event (regarding all financial reporting impacts). Remember, RITM has 10+ underlying investment sub-portfolios. As such, the final organization chart could be tens of combinations. While, yes, RITM’s BV per share will change if/when a spin-off actually occurs, I continue to point out current RITM shareholders will not be "losing anything" as RITM’s BV decrease will merely transfer to the spun-off entity (which shareholders would own as well). There continues to be the strong likelihood some “value creation” will be unlocked if NewRez (and all affiliated entities) is spun-off.
4) Federal (“Fed”) Funds Rate: Regarding Federal Open Market Committee (“FOMC”) monetary policy, my previous projection of 2 - 3 rate cuts during 2024 was revised down to 1 - 2 rate cuts back in April 2024. I continue to believe the first Fed Funds Rate cut will either be in September or December 2024.
As a reminder for subscribers, mREIT/BDC earnings assessment articles take a deeper dive into each company's operational performance metrics and future catalysts/trends. Refer to those articles for company-specific details.
Weekly Recommendations
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 any delay is just in preparing and posting this article.