Weekly Series: mREIT And BDC Recommendations (And Price Targets) As Of 10/08/2023
We aim to retain the same layout from week to week. The layout is carried over from last week.
Weekly Notes From CWMF
Positions: Purchased shares of Alexandria (ARE) on 10/04/2023 at $96.78 and shares of CIM-D (CIM.PD) (CIM.PR.D) on 10/06/2023 at $20.32.
As mentioned last week, I was looking for shares with upcoming floating dates. I added a bit to CIM-D for that reason. With CIM-D I’m just hoping the economy doesn’t fall apart and elevated rates last for several more months. I feel the macroeconomic stress, which gives me a preference for defense (cash or risk rating 1.5 preferred share rather than 4.0). However, the potential return is outstanding for a scenario where we would just need the status quo roughly maintained.
The extra yield on shares relative to Treasuries isn’t high enough to bring me into the position. The fixed yield is pretty good, in the upper 9% range, but not enough to merit taking much risk when Treasuries are high. However, the floating yield would be quite a bit over 13%. That could push the price up, as investors are much more prone to like shares at a double-digit yield. But I’m in this play for the capital gain. If the market reprices off the yield, it represents a nice return over the next 2 to 3 quarters.
I see signs of stress in the economy, but the market is far from a panic. It isn’t showing the level of concern that would justify these prices when such a large dividend increase is on the horizon. The S&P 500 is only 6.5% off the 52-week high. Those investors were not running to Treasuries either, as Treasury yields continue to climb.
For ARE, the trade was driven more by how severely the stock has been pounded and the strong balance sheet (fixed-rate debts and long maturities) positioning them better to deal with higher rates. Higher rates still create some pressure by making their development pipeline less attractive, but it also pressures other potential developers to scale back on supply. Interest rates have a lagged impact on development though, because development takes years. Companies won’t stop a project that is 80% complete because the cost of debt went up. They may scrap some ideas that were near starting, which reduces future supply.
Looking at the mortgage REITs, prices and BVs were down. Prices generally took a bigger hit. Sometimes a much bigger hit. BDCs also saw prices fall. On average, BDC prices were down 3.2% compared to a 0.8% reduction in projected NAV for the BDCs.
We have updates for a few charts. Specifically, the weekly series now has the projected Q3 2023 earnings and BVs across the mortgage REITs and BDCs. Charts show projections and the magnitude of the impact over the quarter as well as the trend in earnings. When earnings are announced, the results are added to the chart (for the next week and thereafter) and compared with projections.
The updated charts also include the projected ranges for dividends across the mortgage REITs and BDCs. The new Q3 2023 charts are replacing the Q2 2023 data, but the layout is nearly identical. The one change is that RC was reclassified from the “originator/servicer” group to the “hybrid” group. I’ll have it moved to the hybrid mortgage REIT category for the Google Sheets soon as well.
Weekly Notes From Scott
Positions: I increased my RC position. This RC purchase was approximately double the size of my purchase the prior week. This new position is reflected in the applicable shared spreadsheet.
BDC Weekly Change: NAVs slightly decreased. Spreads slightly - modestly widened.
Other Comments: Similar to the prior week, more volatility in high yield/speculative-grade debt. This was “in-line” with general market sentiment/performance during the week. This was already anticipated. As continuously noted, I have expected an eventual mild recession to pressure NAVs late 2023 - 2024. This was/is already factored into price targets. I previously stated spreads will likely widen beginning in fall 2023 as they were very tight relative to history.
Underlying Portfolio Company Credit Changes Held by BDCs (Weekly): 1 downgrade (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.
PSEC: (1) Down
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 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). 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.
MREIT Weekly Change: BVs continued their negative momentum from the prior 4 weeks and decreased. In fact, another very volatile week for agency MBS spreads. All BV decreases were modest - notable (from a weekly perspective) for the agencies and less severe for the other 3 sub-sectors (hybrids, originator + servicers, and commercial whole loans). The only mREIT projected to have a relatively unchanged weekly BV was RITM with the company’s proportionately very large net (short) TBA MBS position and very large MSR sub-portfolio (offset by the company’s non-agency MBS/whole loan holdings).
Other comments: Even with projected BV declines across the agency mREIT sub-sector, stock price decreases, in some cases, were less severe. As such, ARR, IVR, NLY, and ORC were upgraded to a HOLD/appropriately valued from SELL/overvalued. ARR’s stock price was particularly “hard hit” directly due to the company’s 1:5 reverse stock split which took effect last Monday. With similar stock price declines but projected less severe BV declines (amongst the many underlying factors impacting risk ratings and price targets), MFA and RITM were upgraded to a STRONG BUY/notably undervalued (see the accompanying tables for details). All agency MBS coupons experienced modest - notable price decreases (including all specified pools; mainly HARP and LLB loans). All (short) derivative instrument valuations only slightly - modestly increased. Simply put, the vast majority of spread relationships I/we track (over 100 combinations) modestly - notably widened. Spread/Basis widening has continued to move past 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 but that has yet to occur. Repo financing slightly increased during the week.
View: Same as last week. Agency mREIT sub-sector valuations remain unattractive (while better than last week, continue to wait for a better opportunity to initiate/increase one’s position). Simply put, as continuously noted, 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 3 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 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 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).
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.
It’s time for the paywall; we’ll get into the charts right after that.
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