Get ready for charts, images, and tables because they are better than words. The ratings and outlooks we highlight here come after Scott Kennedy’s weekly updates in the REIT Forum. Your continued feedback is greatly appreciated, so please leave a comment with suggestions.
You’ve probably seen the volatility in interest rates lately. If you’re reading Seeking Alpha, you can’t help but know about it. There is a lively debate about whether the Federal Reserve simply must raise interest rates to fight inflation, or if some members of the Federal Reserve simply want to “do something”. The increased volatility in interest rates is hard for mortgage REITs (hurts BV per share), but it can also put some pressure on the preferred share prices.
It is easy for investors to believe that higher Treasury yields means all other investments must trade at lower values. It’s easy to believe, but that doesn’t make it accurate. In many cases preferred share prices were effectively capped by call risk. Let’s start with a simple example:
If a preferred share pays out 8% on call value ($2.00 on $25.00 call value) and can be called at any point, what’s the most you would theoretically pay for that share?
You should be asking about the frequency of the dividends. If they are paid out quarterly at $.50 per share, then right before the ex-dividend date the investor would be confident in getting at least $25.50 per share if they were called immediately. For simplicity’s sake, I’m not going into the adjustments on the final dividend when shares are called. There are scenarios where you might be confident in something slightly greater than $25.50, but it’s outside the scope of this article.
So, if you really wanted this share and were confident in the underlying quality of the REIT, you may well be willing to risk at least a few pennies and bid a bit over $25.50 just prior to the ex-dividend date. However, you would have absolutely zero interest in bidding $26.50 for the shares. You know they can be called, so paying $26.50 is risking between $1.00 and $1.50 to the loss on call. Again, we’re assuming that the underlying company is not facing major risk.
Since 8% is a great coupon rate regardless of Treasuries paying out 0.5%, 1.5%, or 2.5%, you would probably expect shares to trade between $25.10 and $25.70 per share most of the time. If you agree so far, then you’re right. That’s precisely how the market has functioned over a period of several years. However, when interest rate volatility increases it can push prices lower. For relatively brief periods of time (generally weeks to months), we’ve seen prices dip in response to rapid increases in interest rates.
Who Sells Today?
Investors who are dumping these shares today tend to use the following reasoning:
Other investors will be scared worse than me in the future, so I can buy it back cheaper.
Are they right? Sometimes yes, sometimes no. If they are wrong, they end up rebuying at a later point and a higher price. I prefer to take a longer view.
I’m focusing on where these shares will most likely be in a year or two. In some cases, we’re looking at floating rate shares. In other cases, we’re looking at fixed-rate shares. Generally speaking, the fixed-rate shares should usually be more exposed to higher rates. Higher rates won’t increase their dividend rate, so higher rates just make other investments more attractive by comparison. But does it change the field enough? If you’re getting a steady 7% or 8%, you’re not replacing that with a Treasury even if it yields 2.5%.
That’s the key factor which helps the shares recover. Their prices were not limited to around $25.00 previously because that was the “perfect price” based on discounting 30 years of potential dividends. They were limited around $25.00 because the call risk makes a large premium dangerous.
We had a few months where preferred share ratings were really boring. It was pretty much all neutral ratings and overpriced ratings. Good entry prices simply weren’t available and that was a bummer. When prices get high, investors gravitate towards whichever analyst is willing to be the most bullish (help them lose the most money). Today, we have a huge volume of preferred shares back in the target buying ranges. More than half of the shares we cover, which is a huge increase from having around 0% to 2% in our bullish range.
For floating rate shares, the expected increase in short-term rates will increase their dividend rates. You can try to apply a higher risk discount rate to those future cash flows, but they are larger cash flows. If the share only has a fixed-rate for another couple of years those shareholders would actually like to see higher short-term rates.
There are some shares that should be facing real pressure. Preferred shares with a fixed-rate coupon that is fairly low (something around 4.5% for instance) should be facing significant pressure. If the coupon rate is that low, then the spread between the Treasury and the preferred share becomes more relevant. This is precisely the reason we’ve avoided covering preferred shares with lower coupon rates. It would require adjusting price targets too much based on swings in bond yields.
What We Bought
We opened a new position recently to take advantage of the abrupt decline. We purchased shares of AGNCP. We’re working on an updated layout or the index card, so let us know what you think of the change in layouts. The two cards below present the exact same information in a slightly different layout:
So why did we buy AGNCP?
Shares offered us several ways to win. If we assume a call, then the 8.8% yield to call is great. Further, that would be 8.8% over the next 38 months. It isn’t just one or two lucky months. So that’s a positive scenario. We would have to consider that a win. What if we assume shares will not be called? The discount to call value still gives us a healthy chunk of upside in the price. But what if the price doesn’t recover? Would we consider it a terrible outcome to get a 6.58% stripped yield? No, that would be pretty good. Another win.
Let’s look several years down the road. If the yield curve is accurately predicting future interest rates, then we’d be looking at short-term rates running a little below 2%. If short-term rates were 2%, the 4.7% spread would require dividend payments at 6.7% of the call value. That’s an annualized rate of $1.675 per year. The shares currently only pay out $1.5313 per share per year. So, in that scenario, the dividend rate would increase by 9.3%. The yield on today’s price in that scenario would become 7.14%. That’s a clear win.
What if interest rates increase then decrease again? Okay, if interest rates decrease again, it’s probably to fight another recession which would’ve been triggered in part by The Federal Reserve. Well, in that case I’ve got a pretty resilient preferred share so I’m probably not doing too poorly. Before the surge in interest rates, these shares traded over $25.00 almost every day for 6 months. So, despite the eventual floating rate, investors were still consistently happy to buy the shares above $25.00.
That’s our latest addition to the portfolio and we added a large chunk. We went from having 0% in AGNCP to just over 4% in a single trade.
Investors may be concerned about the increasing Treasury yields. That concern is especially apparent over the last several weeks. We can’t predict where the price will be one week from now. We aren’t focused on trying to predict the exact timing. We’re looking at the fundamentals and seeing a solid deal for investors. Whether prices dip a little more or rally a bit, the shares continue to offer an attractive yield. We expect the share prices will most likely recover to somewhere around $25.00, which provides investors with a healthy amount of upside in addition to an attractive yield while maintaining a relatively low risk profile.
This is far from the only bargain in the sector. As I said before, we have seen a huge increase in the volume of buying opportunities as several shares fall into our target ranges. Further, sometimes similar shares see different changes in the price movement. That can create an opportunity for investors to optimize their positions by selling any of the more expensive shares and shifting into the cheaper alternative. This weekend I’ll be working on an article for subscribers going over those opportunities using Friday’s closing prices.
The rest of the charts in this article may be self-explanatory to some investors. However, if you’d like to know more about them, you’re encouraged to see our notes for the series.
We will close out the rest of the article with the tables and charts we provide for readers to help them track the sector for both common shares and preferred shares.
We’re including a quick table for the common shares that will be shown in our tables:
Let the images begin!
Residential Mortgage REIT Charts
Source: The REIT Forum
Commercial Mortgage REIT Charts
Q4 2021 Charts
Several of these companies have not reported Q4 2021 values yet. If they have not reported, or reported very recently, they will not have a bar in the following charts:
Preferred Share Charts
Preferred Share Data
Beyond the charts, we’re also providing our readers with access to several other metrics for the preferred shares.
After testing out a series on preferred shares, we decided to try merging it into the series on common shares. After all, we are still talking about positions in mortgage REITs. We don’t have any desire to cover preferred shares without cumulative dividends, so any preferred shares you see in our column will have cumulative dividends. You can verify that by using Quantum Online. We’ve included the links in the table below.
To better organize the table, we needed to abbreviate column names as follows:
- Price = Recent Share Price – Shown in Charts
- BoF = Bond or FTF (Fixed-to-Floating)
- S-Yield = Stripped Yield – Shown in Charts
- Coupon = Initial Fixed-Rate Coupon
- FYoP = Floating Yield on Price – Shown in Charts
- NCD = Next Call Date (the soonest shares could be called)
- Note: For all FTF issues, the floating rate would start on NCD.
- WCC = Worst Cash to Call (lowest net cash return possible from a call)
- QO Link = Link to Quantum Online Page
Our goal is to maximize total returns. We achieve those most effectively by including “trading” strategies. We regularly trade positions in the mortgage REIT common shares and BDCs because:
- Prices are inefficient.
- Long-term, share prices generally revolve around book value.
- Short-term, price-to-book ratios can deviate materially.
- Book value isn’t the only step in analysis, but it is the cornerstone.
We also allocate to preferred shares and equity REITs. We encourage buy-and-hold investors to consider using more preferred shares and equity REITs.
We compare our performance against 4 ETFs that investors might use for exposure to our sectors:
Source: The REIT Forum
The 4 ETFs we use for comparison are:
One of the largest mortgage REIT ETFs
One of the largest preferred share ETFs
Largest equity REIT ETF
The high-yield equity REIT ETF. Yes, it has been dreadful.
When investors think it isn’t possible to earn solid returns in preferred shares or mortgage REITs, we politely disagree. The sector has plenty of opportunities, but investors still need to be wary of the risks. We can’t simply reach for yield and hope for the best. When it comes to common shares, we need to be even more vigilant to protect our principal by regularly watching prices and updating estimates for book value and price targets.
- Bullish on preferred share AGNCP