Cherry Hill - Another New Preferred With An 8% Yield

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About: Cherry Hill Mortgage Investment (CHMI), CHMI.PA, Includes: NYMT, NYMTN, TWO, TWO.PC
by: Rubicon Associates
Summary

Another mREIT preferred stock has been issued with a rate above 8%.

The new Series B Cherry Hill preferred has a lower yield than their outstanding issue, I will explain why it does and why I don't care.

My thoughts on this new 8% yielder.

I put out a note the other day on a new preferred stock issue by Chimera Investment (NYSE:CIM) where I noted that it was the first mREIT preferred since September of last year. No sooner did the market digest that issue that another mREIT tapped the preferred market. The newest issue was done by Cherry Hill Mortgage Investment Corp. (NYSE:CHMI)

Details of the new issue are:

Source: author compiled

Issuer Information

Cherry Hill Mortgage Investment Corp. (CHMI) is a mortgage REIT focused on acquiring, investing in and managing residential mortgage assets in the United States.

CHMI invests in residential mortgage backed securities ("RMBS"), primarily those backed by 30-, 20- and 15-year fixed rate mortgages that offer favorable prepayment and duration characteristics. Their RMBS portfolio consists primarily of Agency RMBS on which the payments of principal and interest are guaranteed. They have also invested in Agency CMOs consisting of interest only securities (a built in hedge) and risk-sharing securities issued by Fannie Mae and Freddie Mac, as well as non-Agency CMOs which are private label securities that are issued by a non-government related entity.

CHMI is externally managed by Cherry Hill Mortgage Management, LLC, an SEC-registered investment adviser established by Stanley Middleman. The manager is a party to a services agreement with Freedom Mortgage Corporation, which is also owned and controlled by Mr. Middleman. The company pays the manager the management fee which is payable in cash quarterly in arrears, in an amount equal to 1.5% per annum of the company’s stockholders’ equity

The following is a snapshot of CHMI's portfolio.

RMBS:

Source: company 10-Q

The RMBS portfolio is a more conservative mixture of agency issued securities, although 25% of the portfolio is comprised of single state issues and HARP/MHA backed securities (which have a more stable prepayment characteristic given the nature of the borrower and the programs that they refinanced under.

MSRs:

Source: company 10-Q

The MSR portfolio is a built-in hedge (like the IOs), where higher rates increase the value of the MSR as the loans should be outstanding for a longer period of time.

As the following chart shows, the net interest margin on the portfolio has remained relatively stable over the last few years, although it recently experienced a minor compression (higher short rates - funding - with lower/stable long rates):

Source: author spreadsheet

Before digging into the new preferred stock, it is always worthwhile to see if it is even worth digging into. The quickest way to determine this is looking at the coverage of the preferred dividend. As most preferred stock is purchased for income, the ability to pay the dividend is paramount. The following table shows the core earnings coverage of the preferred dividend.

Source: author spreadsheet

At 7.4x, the preferred dividend is comfortably covered. Assuming around $1 million in additional preferred dividend a quarter and the funds being deployed 5x leveraged, the additional core earnings generated should be higher than the additional dividends, keeping the coverage multiple stable or marginally higher.

The following is a summary of Cherry Hill's outstanding preferred stock (now comprised of two series):

Source: author spreadsheet

The current pricing/market data on the preferred is as follows:

Source: author spreadsheet

Currently, an investor pays up three basis points (and $0.24) to buy into the new issue. The lower yield appears to be compensation for the fixed to float coupon structure, which is often better due to the duration impact (it lessens effective duration). I currently own the Series A (CHMI.PA) and do not feel compelled to swap into the new series, despite the more favorable duration profile. This is mainly based on my near to intermediate interest rate outlook which does not call for significantly higher rates. Should this outlook change, I will reassess the swap. That said, while the swap may not make sense, the yield on the new preferred is attractive in an absolute sense (i.e., its 8%), but from a relative standpoint (based on where the existing trades and has traded) it is where it should trade, and therefore neither cheap nor rich.

Investors obviously have other options from which they can choose. The following table (and charts) compares the CHMI preferred(s) to preferred stock of peers.

Source: author spreadsheet

As the table above (and charts below) show, the CHMI preferreds provide a higher yield than many of the peers; in fact, the only mREIT with higher available yields is New York Mortgage Trust (NYMT) with their Series D (NYMTN)

The stripped yield, graphically:

Source: author spreadsheet

The yield-to-call, graphically:

Source: author spreadsheet

In order to see if the new issue is trading in line with expectations, I compared it to Two Harbors (TWO) Series C (TWO.PC). The CHMI A is trading exactly on top of the average spread to TWO - again, not rich, not cheap - at value.

Source: author spreadsheet

As many readers are aware, I also look at the spread between the common and preferred to gauge the "cost" of stability for the preferreds. As the preferred dividend has seniority to the common dividend and is a fixed rate, this stability often comes at a price. The following table shows the "cost" of the stability among the peer group.

Source: author spreadsheet

From a cost perspective, Cherry Hill is attractive as investors give up less for the stability than they do with the peer group.

Source: author spreadsheet

Looking at the spread differential historically, the CHMI preferred/equity spread is closing in on its historical tights and is over 50 basis points below its average. From this perspective, the preferred stock is cheap (although I would argue the common is rich).

Source: author spreadsheet

Similarly, one can view the yield on the common relative to the risk free rate (I am using the 10-year Treasury) to determine the risk premium. As one would expect, given the higher yield, CHMI reflects a higher risk premium.

Source: author spreadsheet

The spread to risk free, graphically:

Source: author spreadsheet

The following chart looks at the historical spread to risk-free of the Series A. The chart demonstrates that the spread is near its widest point, given the rally in the risk-free rate and the price stability of the CHMI.

Source: author spreadsheet

From an equity perspective, Cherry Hill has been one of the top performers over the last year:

Chart Data by YCharts

Earlier, I stated that I could argue the common is rich. Consider the following chart, which shows the price to book ratio:

Source: author spreadsheet

Price to book above 90 (currently 95) is a tad rich (prefer it in the 80s), and I would not be surprised to see an equity issuance in the near future (2x in 2018 - 5/30 and 8/31, they issued shares around 95% P/B).

Bottom Line: I like the portfolio of Cherry Hill Mortgage and believe that the preferred stock is comfortably covered (which is why I own it). For existing Series A investors, I do not see a real swaportunity here as the give is around 3 basis points (at mid, more on bid/ask basis). New investors might opt for the fixed to float structure of the new issue as it often provides a better duration profile, but given my outlook for rates in the near/intermediate term, I don't see a clear reason to prefer one over the other, I would simply buy the cheapest. The yield on the CHMI preferred stock is attractive, but I do not believe it is either rich or cheap, so I am assigning it a market perform rating.

Helpful Links

Cherry Hill Series B prospectus

Cherry Hill Series B term sheet

Cherry Hill Series A prospectus

Cherry Hill most recent 10-Q

Cherry Hill most recent 10-K

Scott Kennedy's landing page. He has covered CHMI and is among my favorite authors on the subject. If you don't follow him, you should consider it.

Disclosure: I am/we are long CHMI.PA, CIM.PB, NLY, NYMTN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.