Weekly Series: mREIT And BDC Recommendations (And Price Targets) As Of 10/22/2023
We aim to retain the same layout from week to week. The layout is carried over from last week.
Weekly Notes From CWMF
Positions: No trades for CWMF. I may buy something over the next week. I'm still interested in preferred shares that float soon. Some major weaknesses in equity REIT prices are also tempting. The trend in 10-year yields continues to make that feel pretty dangerous though.
Commentary: Book values got smashed last week. I published a note on Wednesday (October 18, 2023) warning investors that book value estimates were already out of date because of the huge swings. I put together a quick chart to demonstrate the average swings for share prices and book value:
Commercial: With the tiny adjustment for commercial mortgage REITs, I want to remind investors that the commercial mortgage REITs do not have to mark the assets to market. If the loan is not impaired, it can still be held at historical amortized cost (which may exceed market value). That can lead to much lower volatility in “book value” so long as the loans are performing and held to maturity.
Agency: It appears that the market really nailed the adjustments on agency mortgage REITs. It did not. AGNC had the biggest projected loss in BV but the smallest drop in share price. Consequently, AGNC continues to be an absolutely dreadful choice. Price to projected tangible BV as of this weekend is about 1.20.
Of course, when rates swing this wildly, it is more difficult to nail the change in book value. When rates swing like this, the duration profile for the mortgage REIT changes. If management makes zero changes to assets and hedges, the duration exposure would generally increase as rates move higher. To simplify the concept:
Rates up 1% is more than twice as bad as rates up 0.50%.
Therefore, when rates are ripping higher (like today), there is an added level of difficulty from predicting how much management is changing the portfolio. When volatility is this high, having an expert doing the modeling is very important. It is also important to recognize that no one can nail every estimate, especially in this environment.
I want to drill that point home.
Imagine your friend started Q3 2023 with the following portfolio:
Long 100 shares of the VanEck Mortgage REIT Income ETF (MORT).
Short 30 shares of Invesco KBW Premium Yield Equity REIT ETF (KBWY).
Assuming there was no fee for borrowing thos shares to short (only paying the dividend), could you calculate the value of their portfolio at the start of Q3 2023 and again today?
The following table demonstrates the calculations:
This is a dramatically simplified version since there are only two positions and every value is always immediately publicly available.
Easy enough to follow?
Now imagine doing that same math, but you know your friend is interested in placing trades whenever volatility increases.
Can you still be precise? Not so much. You know volatility increased, so he probably placed some trades. If you know his tendencies, you may even be able to make some educated guesses about what he traded and when. If you’re trying to be as close to accurate as possible, you’ve got to leverage that knowledge.
You don’t want to be guessing the wrong trades, but you’ve got the expertise to figure out the most likely trades. So you’re going to factor that into your estimate. You don’t get to know the exact trades, but your expertise will still enhance your accuracy compared to just assuming zero changes.
That’s the current environment. It makes estimates less precise, but it also makes them extremely important. There are still some investors who are using book value from 6/30/2023.
AGNC’s tangible book value was $9.39 on 6/30/2023.
Using Scott’s estimates, we believe tangible book value was:
About $9.40 as of 7/28/2023.
About $8.95 as of 9/1/2023
About $7.95 as of 9/30/2023
About $6.85 as of 10/20/2023
That represents a cumulative 27% decline relative to the end of Q2 2023. About half of the projected decline occurred across the first 3 weeks of October.
Are the preferred shares still okay? I don’t see a problem. AGNC’s book value per share is getting shredded, but the share price represents a huge premium. AGNC would be wise to issue any shares they can at the market. If I were them, I would want to pre-announce the results just to clear the way for a huge secondary. If book value is close to our estimates, then issuing shares is by far the most accretive thing management can do. Even if the price-to-book fell from 1.20 to 1.15, it would still be an amazing opportunity to pump out shares.
If AGNC’s portfolio is only worth $6.85 per share and they can pump out shares over $8.00, that’s a no-brainer. It’s not “dilution”. After issuing shares, the equity per share would increase. That would allow AGNC to buy more assets. If the REIT is fortunate enough to have a large premium to NAV, then issuing shares at that premium is precisely how to drive growth.
That’s how Realty Income (O) delivered such high returns this century. Sure, the real estate did okay. But a substantial portion of the value came from developing a reputation that resulted in a premium share price combined with using that share price to issue new shares at accretive levels. It can have a significant positive impact on returns.
No, we can’t just assume that will happen for AGNC. It’s a very rare situation.
Weekly Notes From Scott
Positions: I initiated a small, starter position in MFA on Friday. No sold positions.
BDC Weekly Change: NAVs relatively unchanged. Spreads relatively unchanged.
Other Comments: Similar to the prior week, muted volatility in high yield/speculative-grade debt this week. MAIN and GBDC reported preliminary earnings results during the week. We provided earnings chat notes + articles for those stocks.
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
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. 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: Unlike the prior week, agency mREIT BVs notably decreased during the week. There were less severe decreases within the hybrid, originator + servicer, and commercial whole loan mREITs. Agency MBS spreads “blew out” and notably widened.
Other comments: EFC’s BV was negatively impacted this week, 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. The after hours action in AJX basically tells the story for that company (down ~16%). This general downward movement makes sense as AJX’s stock price has 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. This week, a minor EFC CURRENT BV “true down” adjustment suffices.
Regarding weekly recommendation changes (mainly due to stock price and projected BV changes), EFC was downgraded to a HOLD/appropriately valued. ARR and NYMT were upgraded to a BUY/undervalued recommendation strictly based on valuation. However, be mindful of ARR’s + NYMT’s 4.5 risk rating (high - very high risk; speculative play). In the current environment, I believe it makes sense to wait for a STRONG BUY/notably undervalued recommendation in these names. PMT was upgraded to a STRONG BUY/notably undervalued recommendation strictly based on valuation (though I know some subscribers have reservations on PMT after what management pulled regarding the whole preferred series debacle [fixed-to-floating trying to become fixed]).
Regarding weekly agency mREIT BV movements, all agency MBS coupons experienced 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) notably widened. This past week basically rivaled what occurred way back in 2013 with the 1st notion of the end of qualitative easing ("QE"). Also known as the "taper tantrum" with Mr. Bernanke as Fed. Chairman. Most (if not all) agency mREIT peers have recently been hedging against the "belly" of the yield curve (short-to-intermediate end) while the yield curve has quickly, and notably, steepened (impacting the long-end). So, a company’s typical duration hedging model has just been very ineffective recently. A model based on matching underlying tenors/maturities (as opposed to strictly duration) would have been notably more effective. Management teams could have implemented an extremely negative net duration gap but that still would have only led to a less severe BV decrease. That said, no management team has a “crystal ball” and cannot 100% correctly model out specific interest rate movements throughout the entire yield curve in each and every instance. Still, I am merely pointing out what was the correct strategy to implement over the past several months and it is up to the management teams to identify such risks/trends and quickly adapt accordingly in these types of environments. 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 patient for this to play out. Even though agency mREIT valuations (AGNC aside) are getting more attractive, before considering 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. 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 5 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).
RITM’s BV was recently 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 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.
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.
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