Weekly Series: mREIT And BDC Recommendations (And Price Targets) As Of 10/15/2023

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 shares of PMT-B (PMT.PB) (PMT.PR.B) on 10/13/2023 at $20.4471 per share. PennyMac Mortgage Trust’s (PMT) management has said that these shares will remain fixed-rate indefinitely under the law. Chimera Investment (CIM) had nearly identical language in their prospectus and declared that under the law the shares must float. I agree with CIM’s legal team and disagree with PMT’s legal team.

Commentary: Minimal developments for the week. BDC prices and book values roughly unchanged. Mortgage REIT prices down slightly on average, BV up slightly on average. It’s worth noting that agency mortgage REITs saw:

1. the biggest average drop in share price (down 2.2%) and 

2. the biggest average gain in book value (up 0.9%).

The worst performer in both regards was Orchid Island Capital (ORC). They previewed Q3 2023 results, which drove a slight negative adjustment. Here’s the BV results:

1. Scott projected an 18.5% loss in BV for Q3 2023.

2. ORC reported a 20.1% loss in BV. 

Let’s take a moment to just appreciate the remarkable accuracy there. When changes in BV for a quarter are further from 0% (whether much higher or much lower), it is more difficult to nail estimates. Clearly, ORC was pretty far from a 0%. That was a great estimate. 

Orchid Island Capital also lashed the dividend from $.16 per month to $.12 per share. Down 25%.

Scott’s projections for total Q4 2023 dividends was a range of $.36 ($.12 average per month) to $.48 ($.16 average per month). If ORC maintains their rate at $.12 per month, they will perfectly match the low end of Scott’s projected range. Prior to the cut, ORC was paying out around 22% on book value. Clearly, that wouldn’t last forever. It was a matter of time.

Weekly Notes From Scott

Positions: No purchased or sold positions this week.

BDC Weekly Change: NAVs relatively unchanged. Spreads relatively unchanged.

Other Comments: Unlike the prior 2 weeks, where there was a mini “spike” in spreads, less volatility in high yield/speculative-grade debt this week.  Will monitor the recent developments in the mid-East and broader macroeconomic impacts in the United States regarding private debt/credit markets.  

Underlying Portfolio Company Credit Changes Held by BDCs (Weekly): 0 downgrades, 1 upgrade (ARCC)

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

• 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: Unlike the prior 5 weeks, BVs stabilized - slightly increased during the week regarding the vast majority of peers.  Agency MBS spreads “stopped the bleeding” experienced during September - the first week of October 2023 and slightly tightened.  That said, this was only a minor reversal and BV net movements are still negative thus far during October 2023.  BV increases were very minor - minor (from a weekly perspective) for the agencies and relatively unchanged - very minor increase for a majority of peers in the other 3 sub-sectors (hybrids, originator + servicers, and commercial whole loans).  

Other comments:  RITM’s BV was negatively impacted, to a very minor extent, by the company’s revised proposed purchase price of Sculptor Capital Management (“SCU”) from $11.15 to $12.00 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 CURRENT BV “true down” adjustment suffices.  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.  CHMI was upgraded to a BUY/undervalued recommendation strictly based on valuation.  However, be mindful of CHMI’s 4.5 risk rating (high - very high risk; speculative play).  NYMT was downgraded to a HOLD/appropriately valued recommendation based on valuation.  MFA is starting to show up on my personal radar regarding a potential future purchase.  Regarding weekly BV movements, all agency MBS coupons experienced modest - notable price increases (including most specified pools; mainly HARP and LLB loans).  Most (short) derivative instrument valuations modestly decreased.  Simply put, the vast majority of spread relationships I/we track (over 100 combinations) very slightly - slightly tightened.  Even with this week’s “smidge” of spread/basis tightening, agency MBS spreads remain above October 2022 levels (negative catalyst/trend).  That said, I anticipate this severity of widening to be a relatively short-term event.  Spreads should tighten somewhat heading into 2024 but subscribers need to be a bit patient for this to play out.  Repo financing was relatively unchanged during the week.   

View: Same as last week.  Agency mREIT sub-sector valuations remain unattractive (while generally 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 4 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).  

Weekly Recommendations

NOTE: This article is usually published Sunday evening or Monday morning. Sometimes it takes a bit longer.