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I recently wrote an article about Annaly Capital (NLY) and the effect of rising long-term interest rates, and thought I would also comment about another related investment with good potential: Chimera Investment Corp (CIM). Chimera, much like Annaly, is a Mortgage REIT that primarily invests in Mortgage Backed Securities. However, unlike Annaly, which invests in government backed MBS, Chimera specializes in private MBS. In addition to the interest rate effect I described in my previous article, there are some other factors that cause me to recommend CIM for your portfolio.

Now looking at Chimera's stock chart, it's not necessarily obvious that it is a good investment.

(click to enlarge)

You will see that while Chimera rallied along with the rest of the stock market during the period from October 2011, to February 2012, it has since pulled back. However, I feel this is a good buying opportunity for the reasons I will detail.

Let's start by talking about a phenomenon that should apply to all Mortgage REITs. As I discussed in the article about Annaly, rising long-term interest rates, while eroding the value of the current book, will put the Mortgage REITs in a "sweet spot" for the next few years. Why's that? The Mortgage REITs make much of their money on the "spread" (the difference) between short- and long-term interest rates. Now, the Federal Reserve has pledged to keep short term at basically 0 through 2014, and there are indications that long-term interest rates will start rising. As this spread increases, CIM, NLY and others such as Agency (AGNC), Hatteras (HTS) and Capstead (CMO) will be able to make more money by their usual tactic of borrowing short and buying long.

Simple right? So are long-term interest rates rising? 10-year treasury bonds recently seemed to break out of a tight trading range, but have since popped back down to the 2% range. However, I feel that long-term rates will unquestionably rise, as there is nowhere to go but up from their historically low levels as the U.S. economy continues its recovery. You can read a little more of the details about interest rates and some discussion in my previous article and the associated comments.

One reason contributing to the pullback is some uncertainty in CIM's accounting. Recently, an auditor resigned, among a few other accounting irregularities. Accounting problems create concern over the actual value of the assets as well as the integrity of the company, and many of us have heard Jim Cramer's rule; never invest in a company while there are accounting problems.

Now, I'm no accountant or auditor, but from my reading, it sounds like this is not a very big deal. The current auditor and CIM concur that there are no more disagreements over Generally Accepted Accounting Principles and some of the non Agency items. Basically, it seems to have blown over to me, and I think this makes for a good buying opportunity.

Furthermore, Chimera is cheap compared with other Mortgage REITs, trading below Book Value. Take a look at the chart.

Company

Price to Book Value

Chimera

0.85

Annaly

0.98

Capstead

1.03

Hatteras

1.04

Agency

1.08

Now granted that Chimera does carry more risk than say Annaly due to its exposure to private MBS. Still, in the event of an improving economy, those bonds have more potential for gain.

That brings me to foreclosures. Another concern with Chimera is the elevated levels of foreclosure and defaults here in the U.S. in the wake of the housing collapse. However, foreclosures are slowly petering out, as employment has been increasing. I'll refer you to recent data that declares foreclosures are now at their lowest levels since mid 2007.

Finally, Chimera is keeping its leverage low, under 2 to 1. With the greater risk from the private MBS as well as the theorized upcoming opportunities in bonds, this is a very smart move.

Chimera is currently yielding over 15%, but remember that its dividends are taxed at normal income levels, and are subject to more change than companies that are not defined as Trusts. The high yield, discount to book value, the coming "sweet spot" of a higher spread between short- and long-term rates and lower levels of foreclosures make Chimera a very compelling, if somewhat risky, investment.

Source: Chimera Compelling At These Levels