When you hear of an investment that generates an astonishing yield of 19% it has to make you think of risky junk bonds or some sort of oil and gas royalty program – not exactly the sort of investments most people find attractive right now. And maybe if you learned that kind of yield was generated by a portfolio of mortgage securities not backed by a government agency, it might still seem somewhat on the risky side. But, if the investment had already been discounted based on all of the risks associated with the mortgage securities market leaving limited downside risk with greater potential for upside growth, then you’d at least have to take a long hard look. That is how many investment analysts are describing Chimera Investment Corporation (CIM) stock right now. If you are seeking diversification into high-yield dividend stocks, it may be one to consider alongside some more stable, lower-yielding stock.
Business Model
Chimera operates as a real estate investment trust that invests in a diversified portfolio of residential mortgage-backed securities, and commercial loans and other asset-backed securities. Like all mREITs, it distributes 90% of its income to shareholders. But, unlike many of the high profile agency mREITS, such as Annaly Capital Management (NLY), Hatteras Financial Corp (HTS), and American Capital Agency Corp (AGNC), Chimera invests in non-agency mortgage securities, which means they don’t have the secure backing of government agencies such as Freddie Mac (FMCC.OB) and Fannie Mae (FNMA.OB). Because of that, its portfolio has a greater risk of default due to nonpayment of mortgages.
So, why would anyone assume the greater risk of a non-agency mREIT instead of investing in a government agency-backed mREIT?
The shares of non-agency mREITs tend to by more volatile than agency mREITs, largely due to the risk exposure. So, when the stock prices of mREITs tanked recently (due to external factors not related to the performance of the mREITs), non-agency mREITs fell further than agency mREITs. Industry analysts believe the steep decline came as an overreaction to some recent regulatory rumblings that have the potential to hurt the mREIT industry, not to mention the general nervousness embedded in the market as whole. And, the fact that the risk of default is already priced into the portfolio valuations of non-agency mREITs, their current stock prices are viewed as significantly oversold, meaning there is more upside potential than downside risk in the price. Chimera recently closed at $2.92 well off of its 52-week high of $4.36 and its price-earnings ratio is well below the industry average.
Recent Rebound
With that oversold condition, mREIT shares have rebounded strongly in October, and the non-agency mREITS, which were hit the hardest in the decline, also bounced the highest in the rebound. Chimera’s stock jumped more than 6% compared with the 2.5% to 3.5% increases in the leading agency mREITs. Analysts see this as a strong indicator that the decline in mREIT stocks is over, at least for the near term.
The other reason Chimera may be a better dividend play than its agency counterparts, is that it maintains a much lower leverage position. Chimera compensates for its higher risk position in non-government agency securities by keeping its leverage well below the industry average of 8% - currently at 1.9%. Right now, the biggest risk facing mREITs is interest rate risk – the possibility that short-term rates rise versus long rates, which is heightened under the Fed’s new monetary stimulus plan, Operation Twist. But analysts insist that the Fed will do whatever it can in the near term to keep short-term rates low. In the event of a rise in short-term rates, Chimera’s portfolio is expected to come under less pressure due to the low leverage factor. Its current dividend ($0.13) is expected to come under pressure, another reason for the recent decline in its stock price, but with a 19% yield, it can come down some and still be tops in the industry.
Summary
FIDAC, a subsidiary of Annaly Capital Management (NLY), is the external manager of Chimera's mortgage backed securities asset selection. Annaly is well-known to be run by top mREIT industry executives, including co-founders Michael A.J. Farrell and Wellington Jamie Denahan-Norris.
A healthy mREIT may include non-agency mREITs and agency mREITs. Hatteras Financial Corp (HTS) owns short-term adjustable rate mortgages (ARMs). These securities are all guaranteed by the Federal government. On the other hand, American Capital Agency Corp (AGNC) owns fixed-term agency mortgage backed securities. Each company operates with a unique business model. Investors are wise to watch for business models that are outperforming the sector.
As with any investment, there’s always downside and upside, but, at least with Chimera, you can be compensated nicely for the uncertainty. As housing prices rebound, the Chimera success story should unfold.
Disclosure: I am long AGNC, HTS, NLY.
