Weekly Series: mREIT And BDC Recommendations (And Price Targets) As Of 11/05/2023

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: Purchased 861 shares of CIM-B (CIM.PB) (CIM.PR.B) at $20.9492 per share.

Consistent with prior commentary, I’ve been looking to increase exposure on the fixed-to-floating preferred shares. CIM slashed the common dividend from $.18 per quarter to $.11 per quarter.

The preferred share dividends are unchanged, of course. The changes don’t start until CIM-B and CIM-D begin floating on 3/30/2024. The floating rate should result in a substantial increase in the preferred share dividends.

Commentary: My major project last week was updates for the residential housing REITs. Those will be posted soon. 

It was interesting to see the magnitude of buying last week. We saw a huge rally hitting all our sector ETFs. To put this in perspective, the ETFs for our sector are up roughly 5% to 9% month-to-date. That’s a pretty big rally, given the last market day was November 3rd, 2023. Agency spreads tightened dramatically. Every agency mREIT gained at 14 least 14% in share price and at least 8% in projected book value. Other types of mREITs also saw big price rallies, but dramatically smaller gains to book value. BDC share prices also rallied hard. 7.6% on average for BDCs. The average book value gain was only 0.4%.

As you might expect, there are a ton of downgrades for both sectors after the substantial rally in share prices.  Rewind just 7 days and we were reporting 9 upgrades and 1 downgrade. The risk/reward profile can shift significantly in a brief period.

What’s driving the rally? The relentless trend higher in interest rates is taking a breather. For the moment, rates actually fell. I would like to see that trend continue because I don’t want to see interest expense on the Federal debt climb into the trillions. Back in 2017, it was “only” $263 billion of net interest expense. Even in 2021, it was “only” $352 billion. But federal debt is at $33.7 trillion. At 4.5%, interest would be $1.5 trillion per year. Nearly double the total defense budget. More than 3 times the total corporate income tax. 

Only a small portion of the debt rolls over each year. Consequently, most people don’t see the real impact of the higher rates until long after they are cooked. Rolling over a small portion each year doesn’t actually save taxpayers money. It just defers most of the interest expense until future years. For instance, higher rates are increasing the deficit by around $250 billion per year. However, each year with elevated rates also leads to another $600 to $900 billion of additional future interest payments from locking in higher rates. That gets smoothed out over many years to hide the impact.

Weekly Notes From Scott

Positions: No purchased or no sold positions.

BDC Weekly Change: NAVs relatively unchanged. Spreads very slightly widened.

Other Comments: Similar to the prior 3 weeks, muted volatility in high yield/speculative-grade debt this week.  Earnings season for the BDC sector remains busy this week.  FSK, SLRC, MFIC, OBDC, and likely PSEC will be reporting.  GAIN received a 3% recommendation range upgrade this week.  More on this upgrade will be provided in an earnings chat note/assessment article (likely out Sunday night).   

Underlying Portfolio Company Credit Changes Held by BDCs (Weekly): 2 downgrades (FSK, SLRC), 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)

• FSK: (1) Down (Medium Joint Venture Investment)

• PSEC: (1) Down (Medium Investment)

• SLRC: (1) Down (Very Small 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 - September 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 into 2024. Already factored into price-to-book targets. Spreads will likely begin widening in late 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).  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 recently prevailed and the next potential government shutdown in mid-November will be continually monitored.  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.    

MREIT Weekly Change: All agency mREIT BVs notably rebounded during the week.  Agency MBS spreads notably tightened which is encouraging.  A good chunk (in some cases most) of the previous October BV declines were erased within the matter of 1 week.  Most hybrid, originator + servicer, and commercial whole loan mREITs experienced more modest/minor BV increases.  CIM received a (6.5%) recommendation range downgrade.  This mainly occurred due to CIM’s surprise notable dividend reduction (2nd notable decrease within just 3 quarters; (52%) cumulative decrease during that timeframe).  Subscribers can read the CIM earnings assessment article for more details.  

Other comments:  Regarding weekly recommendation changes (mainly due to stock price and projected BV changes), many peers were downgraded.  Simply put, stock price increases “trumped” the projected change in weekly BVs (even though both moved notably higher).  Cautious investors should continue to wait for agency MBS spreads to stabilize.  However, I was encouraged by last week’s movements.  Higher risk tolerant investors may want to take “a stab” at initiating positions in a couple of the agency mREITs on any pullback in price (ONLY undervalued or notably undervalued recommendations).   

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 decreased.  Simply put, the vast majority of spread relationships I/we track (over 100 combinations) notably tightened.  Agency MBS spreads have now moved back down to approximately the October 2022 levels (a more positive catalyst/trend).  As pointed out for weeks now, I correctly anticipated the severity of widening to be a relatively short-term event.  I (or really anyone) just could not “pinpoint”, to the exact week, when the reversal would occur.  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.   

View: Same as last week.  Agency mREIT sub-sector valuations are starting to become attractive but, again, I would remain cautious.  Some market participants thought agency mREIT valuations were attractive a few months ago.  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 recent sell-off; in particular AGNC).  Most agency mREITs were recently 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 are likely near their peak and 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).  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 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 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).  

RITM’s BV was recently negatively impacted, to a very minor - minor extent, by the company’s revised proposed purchase price of Sculptor Capital Management (“SCU”) from $11.15 to $12.70 per Class A common share.  Simply something I am already factoring in.  Due to immateriality (again, consider the size of this potential merger when compared to RITM’s existing equity), this revised purchase price does not negatively impact RITM’s percentage recommendation ranges (relative to estimated CURRENT BV) or risk rating.  A very minor - minor CURRENT BV “true down” adjustment in October 2023 sufficed.  If SCU shareholders reject the merger proposal on 11/16/2023, RITM would receive an increased termination fee from $16.6 million to $20.3 million.  

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).  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 will pay 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 not great. AJX’s stock price was hit hard from this news. This general downward movement makes sense as AJX’s stock price had recently held up much better versus basically all mREIT peers (merger price is now “off the table”).  I expect the AAIC/EFC merger to continue. AAIC basically fully hedged itself (asset-to-asset) leading up to the merger.  A minor EFC CURRENT BV “true down” adjustment sufficed during the 3rd week in October.

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: