PennyMac Offers Poorly Valued And Risky Preferred Shares

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About: PennyMac Mortgage Investment Trust CUM RED PFD B (PMT.PB), PMT.PA, Includes: AGNC, AGNCN, ARR, NYMT, NYMTN, PMT, TWO
by: Colorado Wealth Management Fund
Summary

The PMT preferred shares are too expensive.

The shares carry a risk rating of 4 and trade at a premium to call value.

Investors currently invested in PMT preferred shares should look to swap for preferred shares from another mREIT.

This research report was produced by The REIT Forum with assistance from Big Dog Investments.

We cover the preferred shares for PennyMac Mortgage Investment Trust (PMT) at The REIT Forum.

Source: The REIT Forum

These preferred shares do carry a risk rating of 4. We expect them to underperform several of the other mortgage REIT preferred shares over the next year despite having more risk. However, it is most likely that the total return (including dividends) will still be positive. Therefore, we are marking our rating as "neutral" even though we expect other mortgage REIT preferred shares to deliver superior risk-adjusted returns.

A note on our risk ratings

We evaluate the target buy ranges based on all available information (including risk). If we label something a strong buy, we think it is undervalued based on that comprehensive analysis. The risk rating is primarily for buy-and-hold investors and reflects the risk (excluding call risk) level of that security if an investor were to simply buy it, set their dividends to pay out to checking, and log out of the account for the next couple years.

So the risk level is used in picking the target buy prices, but the price itself is not used in creating the risk ratings.

Let's take some examples.

  • ARMOUR Residential (ARR) preferred shares carry a risk rating of 4. 15 years from now, ARR might or might not exist. If we hit a bad recession, management's love of taking on extra risk could lead to a severe punishment for the portfolio.
  • AGNC Investment Corp (AGNC) preferred shares carry a risk rating of 1. If we hit a terrible recession, AGNC would just reposition a little to optimize returns and keep right on being fine. No concerns. An investor could buy AGNCN (AGNCN), set those dividends to pay out, and then ignore the account for the next decade so long as they would get a notice if the shares were called (call protection ends 10/15/2022).
  • As another recent example, we bought NYMTN (NYMTN) and suggested it would be a great dividend capture play. However, it carries a 4. We don't like New York Mortgage Trust’s (NYMT) preferred shares as much for the buy-and-hold investor as we do for trading. For trading, they are more useful because we believe we can see problems coming (anything short of an accounting scandal or insider information) at least a week or two before the market catches on. Sometimes the preferred shares are pretty slow to adjust. Therefore, we’re comfortable trading it but wouldn't suggest it for an investor that intends to log out for months at a time. We’ve already closed out that position for a modest gain.

For the buy-and-hold investor, we would suggest building the preferred shares with mostly 1s and 2s and possibly mixing in a few 3s depending on their risk tolerance.

PMT preferred shares

We cover preferred shares frequently and today’s pick comes our latest article for subscribers: Preferred Shares Week 154.”

If investors feel like trading in the PMT preferred shares, they should not. We would not endorse either PMT-A (PMT.PA) or PMT-B (PMT.PB).

Source: The REIT Forum

We’re not a huge fan of either due to the risk level involved.

PMT-B has a slightly better spread over short-term rates when both are floating (PMT-A has 5.831% to PMT-B at 5.99%), but until then PMT-A carries an 8.125% coupon compared to the 8.0% on PMT-B.

Since both preferred shares are in the buy range, we think buy-and-hold investors who have opted to purchase these should be looking to reallocate capital.

Both preferred shares have call protection on the calendar until 2024. Both preferred shares have a stripped yield just shy of 8%. If all else were equal among the underlying portfolios, PMT’s preferred shares should look significantly better than those of peers. As it stands, the market isn’t too optimistic with 8% yielding preferred shares that have a lot of call protection on the calendar.

The only metric that doesn’t look great, but has improved dramatically is the market capitalization to preferred equity.

5.03x is in the light green but used to be in the yellow.

Final thoughts

We’re not a fan of the risk here. Investors can sacrifice a relatively small amount of yield to pick a safer preferred share. Investors who still want the high yield need to consider the future call risk. The yield-to-call is lower by about 50 basis points because the shares trade above call value. TWO-E (TWO.PE) has a stripped yield over 7.8% and trades at a discount to call value. That is materially better than the yield-to-call for either of the PMT preferred shares. Further, the preferred shares from Two Harbors (TWO) carry a risk rating of 2.5 instead of 4.

Disclosure: I am/we are long TWO, AGNCN, ARR. 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.