Mortgage real estate investment trusts are primed to become more attractive investments for passive income investors as the central bank is poised to lower short-term interest rates and provide the highly leveraged sector with relief in terms of lower financing costs.
Chimera Investment Corporation (NYSE:CIM) is one mortgage trust that I think is worth paying close attention to, since the trust’s stock is selling for an exaggerated discount to book value. The mortgage real estate investment trust just concluded its reverse stock split and is paying an 11% stock yield.
The dividend was covered by distributable earnings in the first quarter, and I continue to anticipate re-rating potential once the central bank implements its first rate cuts.
My Rating History
My stock classification for Chimera Investment was Buy in 4Q23 due to the mortgage real estate investment trust implementing a substantial dividend cut that realigned its dividend with its lower distributable earnings.
As a consequence of this dividend cut as well as ongoing book value losses in a rising-rate environment, Chimera Investment’s stock is still selling for a big discount to book value. The mortgage trust also announced a reverse common stock split, at a ratio of 1-for-3.
I think that the lower dividend pay-out, the excessive discount to book value and the reverse stock split all make Chimera Investment an attractive investment option for passive income investors with a high risk tolerance.
Portfolio Break-Down And Re-Rating Potential In A Low-Rate Environment
Chimera Investment owns a $12 billion portfolio of residential mortgage loans as well as Non-Agency residential mortgage-backed securities. The trust’s residential mortgage loans were valued at $11.1 billion as of March 31, 2024, whereas its Non-Agency residential MBS were valued at $1.1 billion.
Mortgage-backed securities have the feature of increasing in value in a falling-rate environment, which makes Chimera Investment a compelling re-rating play once the central bank cuts its short-term interest rates.
A key part of Chimera Investment’s portfolio is residential mortgage loans, which are interest-earning assets for the mortgage trust. Mortgage real estate investment trusts tend to borrow money on a short-term basis and invest funds into higher-yielding mortgage assets, including mortgage loans and mortgage-backed securities.
Chimera Investment’s net interest spread, a core metric for mortgage trusts that rely on large amounts of debt to earn mortgage security income, was 1.4% in the first quarter, which was unchanged from a year ago.
If the central bank lowers short-term interest rates in the latter half of the year, I would anticipate a higher net interest spread due to the availability of cheaper debt.
Second Consecutive Quarter Of Healthier Dividend Coverage
Chimera Investment earned $0.12 per share in distributable earnings in the first quarter, which equates to a dividend pay-out ratio of 92%. Compared to the previous quarter, Chimera Investment’s dividend pay-out ratio rose 7.1 percentage points, resulting in a smaller margin of safety as far as the pay-out is concerned, but the dividend as such was still well-covered by earnings.
The 39% dividend cut management enacted in 4Q23 was highly effective in instituting stronger pay-out metrics, and Chimera Investment now has two consecutive quarters of a less than 100% pay-out ratio. I think that the dividend is sustainable here, unless Chimera Investment were to sell assets (and lose associated portfolio income) or its distributable earnings would take an unexpected slump.
Big Discount To Book Value
A steepening yield curve, increasing short-term interest rate volatility and widening MBS spreads have done real damage to the mortgage real estate investment trust sector in the last couple of years. This pressure on the business model of mortgage trusts has been reflected in substantial declines in Chimera Investment’s book value, which is the primary reason why the stock is selling at such a big discount at the present time. The rather large dividend cut in 4Q23 is another reason for the large BV discount.
In 1Q24, Chimera Investment’s GAAP book value amounted to $7.11 per common share, which was down from $11.44 in 1Q21. This means that in the last three years, the trust’s GAAP book value, which is a measure of Chimera Investment’s intrinsic value, has declined by 38%.
Since Chimera Investment saw a large decline in its stock price as well, the mortgage trust announced a one-for-three reverse stock split which took effect on May 21, 2024. This stock split could improve liquidity moving forward.
As a consequence, Chimera Investment’s discount to book value has risen to more than 50%, which makes it one of the biggest discounts in the market. Annaly Capital Management, Inc. (NLY) and AGNC Investment Corp. (AGNC) are focused more on higher-quality Agency investments and have not cut their pay-outs lately, which supports their higher book value multiples.
Why I Might Be Wrong
There is one wild card here that passive income investors need to take seriously: The central bank might choose to forgo short-term rate cuts in 2024 if inflation remains a stubborn issue in the latter half of the year.
Investors have some reason to think this, as inflation was resurgent at the start of the year. I do anticipate that the central bank is going to slash short-term interest rates in the fourth quarter, though I might be wrong about this if inflation doesn’t subside.
If the central bank delays rate cuts, Chimera Investment may not profit from lower financing costs in a lower-rate environment. A re-rating catalyst for the trust’s MBS assets (which increase in value if interest rates fall) may also be delayed in lockstep with a delay in the central bank’s rate cut timeline.
My Conclusion
Chimera Investment just concluded a reverse common stock split at a ratio of 1-for-3. This does not change any of the fundamental metrics of the company, except that the number of outstanding shares got drastically reduced and the stock price rose proportionally. The goal here is to make Chimera Investment more appealing to investors and potentially improve liquidity.
Fundamentally speaking, the mortgage real estate investment trust had a robust first quarter as well, as Chimera Investment covered its dividend with distributable earnings for a second consecutive quarter.
If the central bank were to start its rate-cutting cycle in 2024, Chimera Investment would probably face a positive re-rating catalyst for its underlying MBS portfolio.
With a covered 11% dividend yield and a big discount to book value translating into a high margin of safety, I think that Chimera Investment is worth a shot here for passive income investors with an above-average risk tolerance level.
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