Chimera sports a large 16%+ dividend at a time when both the S&P 500 and 10 year Treasury bonds yield less than 2%. So should value investors load up the truck and ride the larger-than-average yield? Let’s take a look under the hood to see if Chimera’s dividend is as good as it sounds.
Chimera is a Real Estate Investment Trust (REIT) that “invests in residential mortgage backed securities, residential mortgage loans, real estate related securities and other various asset classes”, from its website.
Formed as a REIT, Chimera pays out 90% of its earnings to avoid taxation at the corporate level. Chimera borrows money and then invests in cash flow-producing, real estate-related securities. With the recently volatility in these types of products, Chimera has had lots to choose from at discounted prices. The discounted prices help create higher-than-normal yields that Chimera combs through to cherry pick from. The difference between these higher yields and the cost of borrowing for Chimera is how the REIT makes money. In addition to the cash flow, if the investments Chimera buys rise in value, it can sell the asset at a profit instead of waiting for the cash flow payment. However, investors should be aware of the risks of investing in mREITs.
Let’s look at Chimera dividend. As with the case for Annaly (NYSE:NLY), the 16% figure alone does not tell us a lot other than the size of the dividend relative to the current price of the shares. When you look at both the price and the dividend payments, we start to see some problems. The price of Chimera's shares have been greatly underperforming the broad market. In the last year Chimera is down almost 35%. Even when adding back the huge dividend, the negative performance has made owning the stock a losing endeavor. This should not be the case in a year when mortgage-backed securities did relatively well. Directly on the Chimera website we see its mission is the following:
Our objective is to provide attractive risk-adjusted returns to our investors over the long-term, primarily through dividends and secondarily through capital appreciation, by maintaining a business model that evolves with market opportunities.
It seems that the company is failing in its objective of creating capital appreciation this year. At least there is the dividend, right?
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What about the dividend going forward? It is sustainable?
Chimera’s dividend is the main reason investors are attracted to the stock. It does not provide rising cash flows due to sales of some new product or new technology and the associated future earnings. The dividend is the honey attracting the bees. The problem here is that the dividend seems unsustainable at current earning levels. Chimera has already cut back its dividend multiple times. The previous $0.13 has been cut to $0.11 in December, showing the dividend already on the path to seeking a more sustainable level. In fact, the dividend had been in a downtrend since the second half of 2010.
Chimera’s dividend was as high as $0.18 per quarter and is down to $0.11, and the payout is still too high to be sustainable at current earnings levels.
What is more concerning than the amount of the dividend is how Chimera is paying for the dividend. The payout ratio is over 110%- meaning the company is borrowing to pay the dividend. Being a REIT requires the company to pay 90% of earnings, but 110% payout ratio means that Chimera is borrowing from future earnings as well. Dividends are paid from incoming earnings and cash reserves. Cash on the balance sheet shows reserves down to $9.8 million when the last year’s dividend was over $500 million paid out. The dividend is getting paid basically hand to mouth, paycheck to paycheck, quickly burning through Chimera's cash reserves from earnings and apparent borrowing. It would not take much for a crisis to erupt to Chimera if there was an interruption to its cash flow from investments. This is quite unsound financially from a risk standpoint.
The lack of reserves is irresponsible. Not only does it put the dividend at risk, but it puts future dividends at risk by reducing the company’s flexibility. Without the cash reserves, Chimera cannot retire debt early if an opportunity arises. Without the cash reserves, the company is subject to the kindness of its lenders and financing terms. In any threat of rising rates or liquidity crunch, the very debt that allows Chimera to make its leveraged cash flow will be what threatens its survival on both sides. Even if Chimera’s lenders rates or availability are not affected directly, the investments could be affected and, therefore, interrupt the stream of cash flows to Chimera.
The financial crisis of 2008 started in 2007, when liquidity dried up and banks wouldn’t even lend to each other. It was the crisis that dislocated the bond markets and that also created the opportunities for Chimera to invest in. However, it seems unsustainable and slightly reckless for Chimera to keep the dividend the same at such an excessively high rate while depending on the financial markets to provide more financing for future dividends.
Because the dividend is unsustainable and already declining, Chimera seems like a better bet on the direction of the REITs assets instead of the dividend stream. However, given the performance of the stock and the dilution of shares, Chimera is not even a very good choice if were interested in mortgage-related securities. There are far better places for investors, especially value investors, to place their hard earned funds than in the strange malfunctioning contraption that is Chimera. At best it’s a trading vehicle, but it does not even meet the objectives of the directors, unless the objective is to charge management fees.