Weekly Series: mREIT And BDC Recommendations (And Price Targets) As Of 09/03/2023

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: I picked up some shares of PMT-B (PMT.PB) on Monday. Prices were down significantly relative to the prior day thanks to PennyMac Mortgage Trust’s (PMT) announcement. I was only interested in buying them because the shares had declined significantly. We covered the developments extensively in articles last week.

Commentary: Preferred share risk rating and target updates (#1 in subscriber voting) completed last week.

Upcoming:

1. New Portfolio Update because the month is ending.

2. Tower REIT projections (#2 option in subscriber voting from the poll before the PMT chaos)

There are a few macro risk factors that have been at the top of my mind. The first is that the 5-year TIPS yield (the blue line in the following chart) remains at unusually high levels:

We are still near record highs on the 5-year Treasury yield, but the market is forecasting that average inflation (as measured by CPI) will be just slightly over 2% for the next 5 years. The high rate here is putting more pressure on equities as investors are getting an unusually (for the last 15 years) large spread over inflation. Whether that’s “good” or “bad”, it still presses on valuations.

The second factor is the return of student loan payments. The suspension of payments had a big stimulative impact. I suspect many of the households with student debt will find themselves cutting back on expenses. That could drag GDP growth lower and bring us closer to a recession. The Federal Reserve was trying to reduce demand by jacking up rates, but this could be another effective way to reduce demand.

One other note is the trend in home prices. Rather than plunging, we’ve seen a mix of markets where some areas are down and others are up. Many buyers have been going with “all cash” to avoid the high mortgage rates. Overall that’s been positive for residential REITs because the vast majority of renters have no chance at going “all cash”. The combination of high prices and higher mortgage rates eliminates home ownership as an option for many. This has been a tailwind for rents, though the pressure from new supply will worsen (for landlords) before it gets better.

Weekly Notes From Scott

Positions: No new added or sold positions this week.

BDC Weekly Change: NAVs relatively unchanged - very minor increase. Spreads very slightly tightened. 

Other Comments: Similar to the prior 3 weeks, it was another quiet week in high yield/speculative-grade debt.

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, (2) Down

• CSWC: (1) Down

• OCSL: (1) Down

• FSK: 1 Up, (1) Down

• MAIN: 1 Up, (1) Down

• PSEC: 3 Up (Includes 1 Restructuring), (2) Down (Including 1 Bankruptcy)

• GBDC: (1) Down

• SLRC: (1) Down

• TCPC: 1 Up

• OBDC: 1 Up

• TPVG: (1) Down (Declared Bankruptcy)

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: 2 Up (1 Solely Unfunded Commitment), (2) Down

• CSWC: 1 Up, (1) Down

• FSK: (2) Down (1 Portfolio Company Double Downgrade + Declared Bankruptcy)

• MAIN 1 Up, (1) Down

• OCSL: (1) Down

• OBDC: (4) Down, 1 Up

• SLRC: (1) Down 

• PFLT: (1) Down

• PSEC: (4) Down (Already Anticipated Hence Our Prior Recommendation Range and Risk Rating Downgrade Back in May; Prior To The Actual Credit Downgrades)

• TCPC: (1) Down

• TPVG: (3) Declared Bankruptcies

View: Same as last week. - Continuing the June - August 2023 trend, the market remains “cautiously optimistic” on high yield debt/speculative-grade credit.  Spreads 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. 

MREIT Weekly Change: Most BVs continued their positive momentum from the prior week and continued to increase.  That said, most increases were very minor - minor (less enhancement versus the prior week).  Projected BV increases over the prior 2 weeks have partially reversed the downtrend experienced during August 2023 (in particular agency mREITs).   

Other comments:  With their higher durations, agency mREITs, as a whole,  experienced the largest weekly BV increases (percentage-wise).  mREITs who have hedged more against a steepening yield curve were “rewarded” this week.  This was in direct contrast to the trend experienced the prior week where hedging against a flattening yield curve was rewarded.  Most agency MBS coupons experienced modest price increases (including most specified pools; HARP and LLB loans).  Most (short) derivative instrument valuations slightly - moderately decreased.  Simply put, the vast majority of spread relationships (I/we track over 100+ combinations) very slightly - slightly tightened.  We have continued to slightly move away from October 2022/August 2023 spread/basis widening levels in most relationships.  While I correctly expected spread/basis risk to begin to gradually subside the past couple of weeks, even with the recent quick sell-off in August 2023, agency mREIT sub-sector valuations are still not attractive (continue to wait for a better opportunity to initiate/increase one’s position).  Simply put, the market continues to be a bit “ahead of itself” regarding agency mREIT valuations.  Repo financing was relatively unchanged during the week (markets anticipate an unchanged Fed Funds Rate at the September 2023 meeting).  The rate of financing cost acceleration has slowed over the past several months (which was previously correctly anticipated).  

View: Same as last week. Most agency mREITs likely remain in common share issuance mode (rebuild capital as MBS pricing remains historically attractive).  MSR valuations have likely recently peaked but remain elevated versus historical trends.  I/We do not anticipate a notable drop in MSR valuations over the foreseeable future (especially on lower coupons).  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 several quarters).  Net interest spreads will continue moving lower during the second half of 2023 and will likely “bottom out” towards year-end.  Then, a slow, gradual increase will likely begin in early 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.  At GPMT’s level of discount to estimated CURRENT BV, subscribers should be eyeing/hoping for an eventual acquisition/merger by a 3rd party.  Similar to AAIC, this will very likely take some time (especially for this specific sub-sector; likely not until 2024/later in this credit cycle) so subscribers have to be patient with GPMT’s prospects. 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 investments/sub-portfolio trends.  Refer to those articles for company-specific details.  

Weekly Recommendations

NOTE: This article is usually published Sunday evening or Monday morning. Share prices have moved and bond values have moved. These are the ratings and updates as of the weekend. I had to prioritize which research to get to customers first and decided the preferred share updates were the most critical information. 

The updates below were live in the spreadsheets by Sunday night, so the delay is just in preparing and posting this article.

The mREITs: