Source: Wikipedia / Roman Oleinik.
Mortgage REITs like PennyMac Mortgage Investment Trust (PMT -0.30%) and Two Harbors Investment Corp. (TWO 1.12%) are well-known for paying some of the highest dividends in the market, but some investors are hesitant to jump in. Does the extremely high leverage of most mREITs scare you? Are these companies too sensitive to interest rates for your taste? Of these two, PennyMac presents an incredibly intriguing opportunity, as the company buys distressed mortgages and diversifies their portfolio to the point where it is able to hedge against rising rates. Let's take a look at how it has been one of the best performing high-dividend stocks in the market over the past couple of years.
What does PennyMac invest in?
PennyMac Trust mostly invests in distressed mortgage loans, which refers legacy non-performing and reperforming loans purchased at a discount to the underlying property values. They may be behind on payments, entering foreclosure proceedings, or simply made to borrowers with shaky credit or with low documentation. As of the end of 2013, distressed loans made up 63% of PennyMac Trust's holdings.
Because the company invests in distressed loans, PennyMac Trust is able to buy them at a significant discount, which raises their effective interest rate. Think of it as buying a bond for 50% of its face value that pays 5% interest. Well, because you paid so little, it's like your getting 10% interest on your investment. The same idea applies here. This is how Penny Mac Trust is able give investors the high dividends they desire without employing too much leverage. Additionally, because the trust's mortgages are not agency-backed, it eliminates much of the refinancing risk associated with many other mREITs.
Aside from distressed mortgages, 37% of PennyMac Trust's portfolio is made of newly originated loans, agency mortgage-backed securities, as well as excess servicing spreads (ESS) and mortgage servicing rights (MSR). This diversity is why PennyMac Trust is much less sensitive to swings in the interest rate markets than its peers.
A word about mortgage servicing rights (MSRs)
As mentioned, PennyMac Trust is involved in servicing mortgages, which generates fee income. This serves as sort of a hedge against rising interest rates. When rates rise, fewer people prepay their mortgages, meaning the mortgages need to be serviced for a longer period of time, generating more fees. So, as rates rise, these MSRs become more valuable, and can help offset losses in loan income caused by narrowing spreads.
There are other companies that employ MSRs as a diversification strategy, and a good example is Two Harbors Investment Corp. which is set up similarly to PennyMac -- except that it doesn't target distressed loans. So, if the "distressed loans" idea scares you, Two Harbors may be a good option, with a good mix of both agency- and non-agency mortgage-backed securities in its portfolio.
Those who follow the mREITs know about the spike in interest rates in the latter half of 2013 resulting in narrowing spreads that eroded profits and cut dividends. Due to the diversity of its portfolio, PennyMac Trust had no such problems.
The proof is in the performance...
Because of PennyMac's strategy, not only did it maintain its dividend, but it has raised it consistently. In fact, the trust pays out 7% more than it did two years ago.
Not only has it raised its dividend while others made drastic cuts, but its stock performance handily beat its leading peers:
To put things in perspective, consider this scenario of how PennyMac Trust performed in an environment of spiking, volatile rates. If you had invested $10,000 in the trust at the beginning of 2013, it would now be worth about $10,250, assuming you had reinvested all dividends. While this doesn't exactly sound like great performance, consider the same $10,000 invested in either peer would now be worth less than $8,600, and you'll then see where PennyMac Trust's hedges worked.
Why it belongs in your portfolio
In a nutshell, the best reason to buy PennyMac is because it provides the benefits of mREIT investing (high dividends, potential for double-digit annual returns), but doesn't have a lot of the drawbacks (leverage, lack of diversity, sensitivity to rate fluctuations).
For anyone who is serious about creating a high income stream, but still wants to be adequately hedged against swings in rates, PennyMac Trust is definitely worthy of consideration.
