Weekly Series: mREIT And BDC Recommendations (And Price Targets) As Of 08/20/2023

Hi subscribers.

We aim to retain the same layout from week to week. However, when there is an improvement worth changing the layout, we will still make a change. The sections below were reorganized slightly to make the article faster.

The free version of this article contains the weekly notes from the analysts, while the paid version adds targets, positions, earnings performance, and dividend projections.

Weekly Notes From CWMF

Positions: Purchased shares of CCI, SUI, and RC last week.

Commentary: I’m still checking in occasionally on opportunities to swap between the preferred shares. Shares that will float within the next year get some preference as investors seem to bid up shares in the final year before floating begins. Cash is still limited, especially after recent purchases. There’s still a bit on hand, though. When we swap between shares, we’re freeing up capital just in time to use it.

Looking at the mREITs and BDCs, prices are down. For mREITs, book values are also down. Treasury yields are up (bad for book value). Perhaps most notable is the increase in longer-term rates. The 10-year Treasury reached 4.257% to close the week. That’s up from 4.156% a week earlier and 4.038% two weeks ago. The chart below shows the 2-year and 10-year Treasury yields. You’ll notice the 2-year has been pushing up against the same level (about 5%) it was at before the bank failures started. However, the 10-year Treasury has climbed past that level. It is now slightly higher than in November 2022.

Investors might be inclined to think that the higher yields are because of inflation. That sounds right intuitively, but the bond market tells the truth. It isn’t just the Treasury yield that’s soaring higher. The TIPS (Treasury Inflation-Protected Security) is also setting new records:

That’s the global bond market screaming that Federal Reserve is lifting rates way above the expected level of inflation. The bond market says real yields (yields after inflation) are at their highest level in over a decade. That’s the power of the Federal Reserve shoving rates.

How can I be sure that the latest rate increase is not because of inflation expectations? Since we have the yield on the Treasury and the yield on the TIPS, the spread between those two numbers is called the “breakeven” inflation rate. It’s widely used as the market’s prediction for inflation.

Those inflation expectations are roughly flat. Therefore, this isn’t about inflation. The bond market isn’t scared about inflation. The breakeven rate is between 2% and 2.5%. The bond market is concerned about the Federal Reserve pushing rates regardless of inflation.

I’ve got a few things in production. 

• Glossary for common terms investors ask about (but not boring, which is a critical element).

• Earnings review for Realty Income (O)

I may run some polls for which other areas readers are most interested in.

Weekly Notes From Scott

Positions: Added to my existing MITT-C position this week (small - modest increase).

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

Other Comments: Similar to the prior week, it was another quiet week in high yield/speculative-grade debt.  This is contrary to mREIT spreads discussed below.

Underlying Portfolio Company Credit Changes Held by BDCs (Weekly): 0 downgrades + 1 upgrade (ARCC; 1 large debt investment).

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

OCSL: 1 Down

FSK: 1 Up, 1 Down

MAIN: 1 Up

PSEC: 3 Up (Includes 1 Restructuring), (1) Down

GBDC: 1 Down

SLRC: 1 Down

TCPC: 1 Up

OBDC: 1 Up

TPVG: 1 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 - July 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 - early 2024. Factored into price-to-book targets. Spreads will likely widen beginning in late summer - fall 2023. Still tight relative to history. 

MREIT Weekly Change: Most BVs continued to decrease (outside any applicable earnings-related true up (down) CURRENT BV adjustments).  The declines were more severe versus the prior week (in particular agency mREITs).   

Other comments:  With their higher durations, agency mREITs, as a whole,  experienced the largest weekly BV decreases (percentage-wise).  mREITs who have hedged against a flattening yield curve were particularly “hard hit” this week.  This is due to the recent steepening of the yield curve.  Agency MBS pricing experienced a  modest - notable decrease (including all specified pools; HARP and LLB loans).  Derivative instrument valuations slightly - moderately increased.  Simply put, the vast majority of spread relationships (I/we track over 100+ combinations) modestly widened.  We have now reached October 2022 spread/basis widening levels in most relationships.  Along with the nice sector rally earlier this summer, correctly anticipating a widening of spreads was the main reason I exited my DX position back in July.  This was also why, over the past several months, I/we indicated the agency mREIT sub-sector was NOT attractively valued (all 7 sub-sector peers were not deemed a BUY or STRONG BUY recommendation; a majority of peers had a SELL recommendation).  While I expect spread/basis risk to begin gradually subsiding in the coming weeks, even with the recent quick sell-off this past week, agency mREIT sub-sector valuations are still not attractive (continue to wait for a better opportunity).  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-sectors 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) 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

The mREITs: