Introduction
PennyMac Mortgage Investment Trust (NYSE:PMT) is a real estate investment trust that invests primarily in mortgages, also referred to as an mREIT. While the company offers an 11.5% dividend yield on its common shares, the company also offers three separate preferred shares. While the yields between the three are practically equal, and subject to swings on a day-to-day basis, the C Series preferred shares (NYSE:PMT.PR.C) are currently trading at the lowest cost per share, and are my preferred investment.
PennyMac Financial Results
PennyMac has a rather complicated business model that involves more than just investing in mortgages. A review of the financial statements can help unpack what the business does. From a profitability perspective, PennyMac saw declines based on the headwinds in the real estate market continuing due to higher interest rates.
PennyMac’s net interest income (interest income less interest expense) remains negative at $28 million in the first quarter, which is slightly lower than negative $26 million in the same quarter a year ago. This means that the mortgages in PennyMac’s portfolio are paying at lower interest rates than the company’s current cost of financing to invest in those mortgages. This is because of the number of mortgages underwritten during the pandemic at a low fixed mortgage rate, and those loans remain on the books until maturity, while the debt backing those investments is variable and has swung upwards with the rise in interest rates.
Where PennyMac has swung its operations to profitability is through the servicing of mortgage loans. Mortgage servicing is where the company takes on the responsibility of managing the mortgages (facilitating payments, generating statements, etc.) in exchange for a small fee. PennyMac generated $163 million in servicing revenues in the first quarter. When combined with hedging and the net interest loss, the company’s net investment income was $74 million for the quarter, which is $16 million lower than the same quarter a year ago. After taking in operating expenses, which fell by $10 million, net income was $13 million lower at $47 million. Despite the drop in net income, PennyMac is still generating the profitability to cover its preferred share dividends by more than four times over.
By examining the balance sheet, investors can see that PennyMac made some strategic shifts in the first quarter. The company is divesting itself from the total number of loans it holds, while maintaining its mortgage servicing position. The company reduced its mortgage-backed security position by $900 million. Of those proceeds, $500 million went to reducing the company’s repurchase agreement liabilities, $250 million was invested in loans now held for sale, and after a $150 million drawdown in cash, short-term investments were increased by $200 million. Through all these movements in funds, shareholder equity remained stable at $1.96 billion.
What Mortgage Servicing Looks Like
While the balance sheet has nearly $4 billion of mortgage servicing rights on the balance sheet, that is nowhere near the size of the mortgages that PennyMac services. The mREIT currently services over $230 billion in unpaid principal mortgages, with 98% of these mortgages insured by Fannie Mae or Freddie Mac. The loans have an average loan to value of 56%, with a FICO score of 759 at origination.
The move towards greater mortgage servicing will further stabilize PennyMac’s operations. The income from mortgage servicing is far more stable than the expense swings faced by the change in interest rates related to the asset repurchase market. The mortgages that PennyMac service are also performing well, with a low delinquency rate. The stabilization makes the preferred shares and their income more attractive.
Risks
Because of PennyMac’s reliance on short-term financing, investors need to acknowledge that PennyMac faces risks associated with liquidity in the macroeconomic environment. During COVID, many mREITs had to suspend their preferred share dividends and even entered forbearance agreements while they worked through liquidity crunches. Fortunately, many of these companies were able to resume dividends (including arrears) in a short time. In PennyMac’s case, the liquidity risk is somewhat hedged with more than a dozen counterparties, including $3 billion of the $5.1 billion liability being tied into “too big to fail” banks.
In addition to liquidity, investors should be mindful of regulatory changes and how they can affect the profitability of the mortgage servicing arm. At any point, GSEs like Fannie and Freddie can require mortgage servicers to do more with the mortgages they are servicing. For example, back in February, the GSEs announced they were requesting new requirements for servicers to verify that borrowers were constantly maintaining property insurance.
Those Floating Rates Won’t Float
The Series C preferred shares have no floating requirements, but the Series A and Series B did when they were underwritten. Unlike other issuers of preferred shares who shifted from LIBOR to SOFR with the end of LIBOR, PennyMac simply decided to not honor any floating rate and opted to keep the dividend rates fixed on Series A and Series B. This left holders of those preferred issuance slighted by the company’s announcement. Should preferred holders decide to formally push back, it could create short-term volatility in the pricing of all preferred shares.
Conclusion
PennyMac’s shift towards mortgage servicing should continue to stabilize its net income and create a profitability floor that will support preferred dividends. The mREIT is still facing headwinds associated with higher interest rates that have caused its mortgage-backed securities to drag earnings down, but that should reverse when interest rates decline. Overall, the Series C preferred shares offer the lowest entry cost of the preferred issuances with a comfortable 8.8% dividend yield.
Jeremy LaKosh
About My Writing: I am currently focused on income investing through either common shares, preferred shares, or bonds. I will occasionally break away and write about the economy at large or a special situation involving a company I've been researching in.I target two articles per week for publication on Monday and Tuesday.About My Background: Bachelors in history/political science, Masters in Business Administration with a specialization in Finance and Economics. I enjoy numbers. I have been investing since 2000. Professionally, I am the CEO of an independent living retirement community in Illinois.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of PMT.PR.C either through stock ownership, options, or other derivatives. 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.
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