This past year has been particularly difficult for companies in the mortgage market. The abrupt increase in interest rates has crushed mortgage originators, as borrowers no longer have an incentive to refinance their home loans.
Mortgage originators have also struggled with declining home sales, which also has been driven by rising rates and soaring home prices. Finally, the mortgage real estate investment trust (REIT) sector has seen investment portfolios underperform Treasuries, which has caused these companies to report declining book values.
The mortgage REIT sector now has many companies with double-digit dividend yields, and investors are beginning to wake up to the opportunities. So why does Chimera Investment Corp. (CIM 1.26%) have such a high dividend yield?
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Mortgage REITs are different
For newcomers, mortgage REITs aren't like the typical REIT. Most REITs develop or own properties and then lease them out to tenants. It's the classic landlord-tenant business model.
Mortgage REITs don't invest in real estate. They invest in real estate debt, or mortgages. In this way, they resemble a hedge fund or bank.
Chimera is a hybrid mortgage REIT
Chimera considers itself a hybrid mortgage REIT, which means it has a combination of agency mortgage-backed securities, which are guaranteed by the U.S. government, and non-agency securities, which are not. The company also invests in whole loans and commercial mortgage-backed securities, which go to larger commercial properties. The residential loan portfolio consists primarily of reperforming loans (borrowings that went delinquent and then were brought back to current) and business-purpose loans, largely for fix-and-flip investors.
Chimera makes heavy use of securitization, in which loans are bundled into a security that trades like a bond, to fund its portfolio. This strategy enables Chimera to lock up financing for a longer period and reduces its reliance on repurchase lines, which are subject to margin calls. The downside is that liquidity in the mortgage securitization market tends to come and go.
Mortgage-backed securities have underperformed this year
During the past year, mortgage-backed securities underperformed Treasury bonds. This has resulted in declines in Chimera's book value per share because investors would rather hold Treasuries than mortgage-backed securities.
During the third quarter of 2023, Chimera's book value per share declined from $8.82 to $7.44. The decline in book value caused a loss of $0.88 per share, and the company chose to cut its quarterly dividend from $0.33 to $0.23 per share. The dividend yield, even after the cut, is high because the stock has fallen so much this year, with a 58% decline.
These losses were mainly mark-to-market losses, so if mortgage-backed securities rebound relative to Treasuries, they could be recouped. The underperformance of mortgage-backed securities last year has been driven by rapidly rising interest rates and bond fund outflows.
Mortgage-backed securities are one of the most liquid bond markets outside of Treasuries, and when bond fund managers experience outflows, these securities are among the easiest to sell without impacting net asset value. If bond fund outflows reverse, demand for these securities should increase, especially because mortgage-backed securities offer a highly attractive yield, relative to Treasuries.
Much will depend on the economy and the Fed
Ultimately, the fate of mortgage REITs will depend on the actions of the Federal Reserve. The Fed earlier this week raised the federal funds rate 50 basis points (or 0.5%) and forecast that it might have another 75 basis points to go. It has already hiked rates 4.25% over the past nine months, so we're in the final innings of this rate cycle.
Chimera cut its dividend pretty substantially in September, so another cut is unlikely in the near term. The company does have quite a bit of credit risk in its portfolio, so if the U.S. enters a recession, it could see a rise in delinquencies, which would hurt net income. That said, if interest-rate volatility subsides, the dividend should be safe.
