The past year has been a particularly difficult year for companies in the mortgage market. Rapidly rising interest rates have crushed mortgage originators and borrowers no longer have an incentive to refinance their mortgages.
Mortgage originators have also struggled with declining home sales, also driven by higher interest rates and higher home prices. Finally, in the mortgage real estate investment trust (REIT) sector, these companies report lower book values as investment portfolios underperform government bonds.
The mortgage REIT sector is now full of companies boasting double-digit dividend yields, and investors are waking up to the opportunity.then why Chimera Investment Corporation (CIM -1.59%) Is the dividend yield that high?
Mortgage REITs Are Different
For new entrants, mortgage REITs are different than typical REITs. Most REITs develop or own real estate and lease it to tenants. This is the classic landlord-tenant business model.
Mortgage REITs do not invest in real estate. They invest in real estate debt, or mortgages. In this way, it resembles a hedge fund or a bank.
Chimera is a hybrid mortgage REIT.
We believe Chimera is a hybrid mortgage REIT. This means that we have a mix of agency mortgage-backed securities that are insured by the US government and non-agency securities that are not. The firm also invests in whole loans and commercial mortgage-backed securities that go into larger commercial properties. The mortgage portfolio consists primarily of reperform loans (borrowings that have been delinquent and then returned to present condition) and loans for business purposes, primarily for fix-and-flip investors.
Chimera makes heavy use of securitization. In securitization, loans are bundled into securities that trade like bonds to fund a portfolio. This strategy allows Chimera to lock up funding for an extended period of time and reduce reliance on repurchase lines subject to margin calls. The downside is that liquidity in the mortgage securitization market tends to come and go.
Mortgage-backed securities underperformed this year
Over the past year, mortgage-backed securities have underperformed government bonds. That has caused Chimera’s per-share book value to fall as investors prefer to hold government bonds over mortgage-backed securities.
In the third quarter of 2023, Chimera’s book value per share decreased from $8.82 to $7.44. The decline in book value cost him $0.88 per share, and the company chose to cut its quarterly dividend from his $0.33 to $0.23 per share. The stock has fallen significantly this year, down 58%, so the dividend yield is high even after the cut.
These losses are primarily mark-to-market losses that can be recovered if mortgage-backed securities rebound against Treasuries. Last year’s downturn in mortgage-backed securities was due to rapidly rising interest rates and outflows of bond funds.
Mortgage-backed securities are one of the most liquid bond markets outside of Treasuries, and should a fixed income fund manager experience an outflow, these securities are easy to sell without impacting net asset value. One of the easiest securities. If bond fund outflows reversed, demand for mortgage-backed securities should increase, especially as they offer very attractive yields compared to US Treasuries.
heavily dependent on the economy and the Fed
Ultimately, the fate of mortgage REITs rests on the actions of the Federal Reserve. The Fed raised the Federal Funds rate by 50 basis points (or 0.5%) earlier this week and predicted a further 75 basis points. With 4.25% rate hikes already in the last nine months, we are entering the final round of this interest rate cycle.
Chimera slashed its dividend pretty heavily in September, so another cut is unlikely in the near term. The company’s portfolio has significant credit risk, so if the U.S. were to fall into a recession, delinquencies could increase and hurt net income. That said, the dividend should be safe once interest rate volatility subsides.