Source: The REIT Forum
All of the CIM preferred shares are in our hold range, but CIM-B remains the clear winner. Our buy targets for the preferred shares can be seen in the ‘Buy Under’ column. The most overpriced share is CIM-C, which is $1.90 away from our buy range. However, CIM-B is only $0.82 away from our buy range and is easily the most attractively valued CIM preferred share.
With that being said, we’d like to cover a worst-case scenario that we told subscribers about 2 weeks ago in a previous article.
The worst-case scenario for CIM-B is that rates are being cut because we are clearly plunging headfirst into a recession. If we are flying headfirst into a recession, we would expect credit spreads to widen. In that scenario, prices for the vast majority of preferred shares and common shares would decrease. All investors should be familiar with this concept. If we are entering a recession, credit spreads widen and share prices fall.
Often, we see credit spreads widen and share prices fall without the recession materializing. We’ve witnessed it at least 3 times since 2015. Those were early 2016, early 2018, and late 2018.
Note: We have been correct during the last 3 scares in predicting that a recession would not materialize. However, it isn’t possible to be certain. When prices fall and spreads widen, we can be certain that we have entered a period of fear. We cannot be certain that the recession won’t occur. Consequently, we will describe these scenarios as entering a period of fear.
The worst-case scenario for CIM-B is that we are entering a period of fear, rates are being cut (bringing down the dividend rate), and the share price is falling.
For this scenario, we need to set reasonable expectations. Unless an investor is hedging their portfolio by shorting several stocks, their portfolio value will almost certainly decline. Investors accept this. It is a part of investing. People who purchase stocks without thinking about this are not investing, they are buying and hoping.
One of the best ways to think about this risk level is to use benchmarks. For instance, if we enter a period of fear and our shares fall by 5%, but the average performance among shares is falling by 10%, then we’re in a great position. If we want to reallocate, we can do so. If we want to simply continue holding onto our shares, we can do that also. Either way, we are in a much better situation than most investors.
Remember that this is considered the worst-case scenario. So, we might want to ask how the market reacts to this risk. Fortunately, we got a chance to witness this scenario playing out during December 2018. The markets slid hard with the major stock indexes (such as the S&P 500) losing as much as 20%. A 20% decline certainly qualifies as a period of fear. Were interest rates falling? You bet they were:
Therefore, the December 2018 scare included both the fear of recession and the plunging short-term rates.
So, how did the fixed-to-floating shares with large credit spreads perform? How did the other preferred shares perform? Were fixed-to-floating shares punished worse?
We can start with a chart that goes back to 1/1/2018:
(Note: If the image is confusing, please see our guide to reading the $100k charts)
If a share wasn’t issued until after 1/1/2018, the line begins after the share is issued.
We can safely say that every preferred share within the chart during the first period of fear had at least a small dip. We can also see that the major preferred share index (PFF) had a dip as well.
Things are a little strange during the second period of fear. Some shares don’t seem to dip much. Let’s zoom in:
With this closer chart, we can see that the dip is quite small for 3 shares:
Each of those 3 shares had a floating rate.
However, we need to stress a few additional facts.
- Floating rate preferred shares were not the only ones to hold up well.
- Not all floating rate shares performed well.
- It appears that floating-rate and fixed-rates were relatively minor factors in determining price performance.
The two worst-performing shares (among those charted) during the period of fear were both from New York Mortgage Trust (NYMT). Why did they perform poorly? Probably because of the level of credit risk NYMT uses in their portfolio. NYMTN eventually has a floating rate and NYMTO does not. They plunged together.
What Can We Learn?
The market demonstrated very recently that the perception of risk was the most important factor for price performance going into a potential recession. We don’t believe it was quite accurate in predicting how much risk each share carried, but it had a decent enough approximation.
While we assigned a risk rating of 3 to CIM, the market clearly treats CIM preferred shares as if they had a risk rating of 1 or 2. This is important information if investors are content to consider trading techniques. If the shares hold up well during periods of fear, the investor has the opportunity to swap shares at favorable prices.
If we entered another similar period of fear, we would expect that preferred share prices would move generally in the same manner as they did last time. That means opportunities to swap to a higher fixed-rate share would most likely develop.
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Disclosure: I am/we are long CIM-B, AGNCN. 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.