Hi subscribers.
We aim to retain the same layout from week to week. The layout is carried over from last week.
Weekly Notes From CWMF
Positions:
Sold: MFA, MFA-C. (Correction: MFA-C. Initially said MFA-B).
Purchased: RITM-B.
Commentary: The BVs are up moderately on average for mREITs, but prices were up quite a bit more.
Investors seem to be getting quite a bit more optimistic about interest rates. Inflation projections are dipping and the TIPS yield is also dipping. The combination sends bond yields down quite a bit.
I’ve argued previously that:
Inflation was massively above the reported level in 2021.
Lagged shelter data would drive “inflation” in the second half. The only change in that stance was the tense: Lagged shelter data drove “inflation” in the second half.
Treasury yields are offering a much larger premium to future expected inflation than we’ve seen in a long time.
Looking at the situation today:
Investors are starting to wonder if we may be past the worst of it. For inflation, we probably are. However, the Federal Reserve was slow to admit reality before.
I’m expecting the Federal Reserve will be slow again. So, I’m not convinced we’ll see rate cuts as fast as participants hope.
To be precise, I still believe lower rates would be better (absurd level of national debt). Expecting the Federal Reserve to be late on rate cuts isn’t the same as thinking they should delay them.
The yield in excess of inflation is finally dipping.
We’ve seen some key support levels broken for the first time since May 2023:
Source: MBS Live
The 10-year Treasury broke through the 25-day and 50-day moving averages in November. More recently, it dropped through the 100-day moving average. From a technical standpoint, these are great signs. It’s been a big factor supporting a move higher in REITs.
Breakeven Inflation and Yield Over Inflation
The following chart breaks down 3 metrics:
5-year Treasury yield
5-year TIPS (Treasury Inflation-Protected Security) Yield
5-year Breakeven rate (5-year Treasury minus 5-year TIPS)
Seeing these 3 lines together allows us to evaluate how much of the yield comes from expected inflation and how much comes from investors expecting a premium return.
The 5-year breakeven rate can be thought of as the market’s projection for inflation (based on CPI) over the next 5 years. That comes from two simple observations:
If the market expects inflation above the breakeven rate, then buyers would want to pick the TIPS (and sell the Treasury).
If the market expects inflation below the breakeven rate, then buyers would want to pick the Treasury (and sell the TIPS).
You can even see that the 5-year breakeven rate (projected inflation) peaked in March 2022.
Currently, it stands at about 2.12%.
We are roughly tied for the lowest level since early 2021. Even though the lagged shelter data is propping up inflation today, the global bond market knows it will disappear.
What I find particularly interesting is the difference between the red and green lines. The market understood inflation was going to hit in 2020. By early 2021, it knew we would see heavy inflation. However, it wasn’t until 2022 that the market believed the Federal Reserve would actually be shoving rates higher. While 5-year “inflation” expectations temporarily moved above 3%, they spent most of the last 35 months between 2% and 3%.
Implications
If the market could just demand rates based on inflation, it would’ve happened. Instead, most of the correlation is between the 5-year Treasury yield and the 5-year TIPS yield.
Therefore, the market is focused on forecasting the Federal Reserve. Treasury yields are estimates for future short-term Fed Funds rates. That means the Federal Reserve is still in control of rates. Macroeconomic conditions matter, but they mostly just matter to the extent investors are trying to forecast how the Federal Reserve will respond to them.
General Thoughts
If rates continue to trend lower, I may start opening up more positions in fixed-rate shares. That’s starting to be on my radar more.
However, I will also remain interested in shares that float within the next year or two. Since I don’t expect a near-term cut, these shares should still have substantial dividend increases. Bigger dividends have a way of sending prices higher.
I’ll have some more detailed “preferred share” thoughts to publish coming up in another article for our paid members.
Weekly Notes From Scott
Positions: No purchased positions. As noted during the week, I sold my entire position in MFA on Wednesday.
BDC Weekly Change: Continuing the recent, general trend, NAVs slightly increased. Spreads slightly tightened.
Other Comments: Similar to the prior 7 weeks, muted volatility in high yield/speculative-grade debt this week. Regarding weekly recommendation changes (mainly due to stock price and projected NAV changes), 1 upgrade occurred. GAIN moved from APPROPRIATELY VALUED/HOLD to UNDERVALUED/BUY. Also note GAIN’s $0.88 per share special periodic dividend accrues on Tuesday (stock price and NAV will notably “reset” lower this upcoming week). Most stock price fluctuations largely matched projected weekly NAV changes.
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.
ARCC: 1 Up (Small Investment), (1) Down (Small Investment)
FSK: (1) Down (Medium Joint Venture Investment)
MFIC: (1) Down (Small Investment)
OBDC: (1) Down (Medium Joint Venture Investment)
PSEC: (2) Down (Medium Investment, Large Investment)
SLRC: (1) Down (Very Small Investment)
TCPC: (1) Down (Medium Investment)
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: 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)
View: Same as last week. - Continuing the June - November 2023 trend, the market remains “cautiously optimistic” on high yield debt/speculative-grade credit. Spreads, for the most part, 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 2024. This trend is already factored into price-to-book targets. Spreads will likely begin widening during 2024. Still tight relative to history. Continuing to watch the broader/macroeconomic impacts from the recent end of the 3-year student loan repayment pause (due to COVID-19) in October (and any new updates regarding this event). I correctly assumed the potential government shutdown in mid-November would be averted. I/We will continue to monitor the recent developments in the mid-East and broader macroeconomic impacts in the United States regarding private debt/credit markets. 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 sub-portfolio catalysts/trends. Refer to those articles for company-specific details.
MREIT Weekly Change: All agency mREIT BVs slightly - modestly increased during the week. Agency MBS spreads slightly - modestly tightened. Most hybrid mREITs experienced minor BV increases. Commercial whole loan mREITs experienced a relatively unchanged BV fluctuation. With the quick drop in rates across the entire yield curve, both originator + servicer mREITs experienced a minor decrease in BV.
Other comments: Regarding weekly recommendation changes (mainly due to stock price and projected BV changes), 3 downgrades occurred. BXMT, MFA, and PMT moved from UNDERVALUED/BUY to APPROPRIATELY VALUED/HOLD. Most stock price fluctuations largely matched projected weekly BV changes.
Regarding weekly agency mREIT BV movements, all agency MBS coupons experienced notable price increases (including all specified pools; mainly HARP and LLB loans). All (short) derivative instrument valuations modestly - notably decreased. Simply put, the vast majority of spread relationships I/we track (over 100 combinations) slightly - modestly tightened. Agency MBS spreads have now moved a good bit below the recent October 2023 highs (a positive catalyst/trend). As pointed out for weeks now, I correctly anticipated the severity of widening during late Q3 2023 - early Q4 2023 would be a relatively short-term event. I (or really anyone) just could not “pinpoint”, to the exact week, when the November 2023 reversal would occur. This reversal continued into the 1st week of December.
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. Subscribers need to remain patient on this potential future event (regarding all financial reporting impacts). While I continue to "run" 2 sets of RITM BVs on the potential/future spin-off, it is still too early to publicly provide both sets of BVs since I/we do not know which exact subsidiaries are being spun-off. 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 eventually occurs, I would 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 as NewRez (and all affiliated entities) is spun-off. On a related note, as I've stated from the start, dependent upon the "final makeup" of RITM after the potential spin-off, the REIT Forum will continue to cover the "mortgage operations" of the company. In other words, the REIT Forum will cover the mREIT operations of the company. That will very likely be the spun-off company and might not include the parent (for instance if the parent/RITM merely becomes an asset manager). Again, I currently cannot provide the specifics/breakdown of this spin-off because RITM has not provided such details but I will be on the continued lookout to do so.
View: Same as last week. Agency mREIT spreads will likely remain volatile heading into 2024 (in both directions) so subscribers need to be patient for this to play out. Before I personally consider an investment in this sub-sector based on valuation, I want to see some spread stabilization to occur that lasts more than a week - a couple weeks. Just my personal choice within the agency mREIT sub-sector. Repo financing was relatively unchanged during the week. Higher risk tolerant investors may now want to take “a stab” at initiating positions in a couple of the agency mREITs on any pullback in price (ONLY UNDERVALUED/BUY or NOTABLY UNDERVALUED/STRONG BUY recommendations). Some market participants thought agency mREIT valuations were attractive during the summer of 2023. Simply put, as continuously noted, the market was “ahead of itself” regarding agency mREIT valuations. A perfect example of this was the notable sell-off during September - late October 2023 which we correctly warned subscribers beforehand (regarding this sub-sector being overvalued prior to this prior sell-off; in particular AGNC).
Most agency mREITs remain in common share issuance mode (rebuild capital as MBS pricing remains historically attractive). However, some agency mREITs trading at notable discounts to estimated CURRENT BV will likely temporarily stop or notably reduce common stock issuance unless deemed necessary (due to greater BV dilution). MSR valuations were recently at their peak but remain elevated versus historical trends. However, I/We do not anticipate a notable drop in MSR valuations over the foreseeable future (especially within lower coupons). Prepayments, across the mortgage landscape, have remained relatively subdued (even with the recent quick drop in rates/yields) but technically have “ticked higher”. 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 quarter or 2). 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 (BXMT was a perfect example of this during Q3 2023; 3 new non-accrual 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 should be followed by ACRE and then GPMT. 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 (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).
RITM’s BV was recently negatively impacted, to a very minor - minor extent, by the company’s revised purchase price of Sculptor Capital Management (“SCU”) from $11.15 to $12.70 per Class A common share. I have already factored in this change. A very minor - minor CURRENT BV “true down” adjustment in October 2023 sufficed. On 11/17/2023, SCU common shareholders (Class A + B) overwhelmingly voted FOR the RITM merger proposal (by nearly a 10:1 ratio). This ends a long, drawn-out/drama-filled process. Subscribers can simply use the chat search feature within this service to see the many, detailed conversations over the past several months in relation to the RITM/SCU merger (most important, the impact to RITM’s future operations).
EFC’s BV was negatively impacted in October 2023, to a minor extent, by the company’s termination of its previously announced merger with Great Ajax Corp. (AJX). That said, a 9/30/2023 BV “true-up” recently occurred as EFC increased the company’s hedges to account for the upcoming termination. So, more of a “timing event” on BV fluctuations. Termination fee aside, I don't mind this development/decision. Out of EFC’s 2 previously announced mergers, AAIC is more important/appealing in my opinion. That said, I am not thrilled by the $16 million termination fee EFC is paying but probably the lesser of 2 evils down-the-road. If I had to take a guess, EFC backed out of the deal. EFC is receiving a minor position in AJX via part of the termination fee but at a price of $6.60 per common share which is bad (stock currently trades well below this amount). I expect the AAIC/EFC merger to be finalized/cost during December 2023. AAIC continues to basically fully hedge itself (asset-to-asset) leading up to the merger.
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 the delay is just in preparing and posting this article.
The mREITs: