Preferred Stock Of Chimera Highly Attractive For Income-Oriented Investors (NYSE:CIM.PR.A)

Pgiam/iStock via Getty Images About seven months ago, I recommended purchasing the preferred stock of Chimera Investment Corporation (NYSE:CIM.PR.A) before its yield decreased further. Since my article, the stock has offered a total return of 13.4%, which is an exceptional return for a fixed-income security in less than 7 months. As the preferred stock has appreciated since the article, its yield has decreased from 10.2% to 9.2%. The common stock of Chimera (CIM) has been under great pressure in the last three years. Due to the surge of short-term interest rates and the resultant inverted yield curve, the earnings of the company have plunged. Consequently, the stock has slumped 71% over the last three years and has reduced its quarterly dividend by 65% during this period. However, investors should realize that the worst is behind the company. In addition, the preferred dividend of the REIT is much safer than its common dividend. Therefore, those who have missed the exceptional returns of the preferred stock should lock in its 9.2% yield before it decreases further. Business overview Chimera is a REIT that was founded in New York in 2007 and became internally managed in 2015. Its business involves borrowing funds and investing the proceeds in residential mortgage loans and non-agency residential mortgage-backed securities. As the company borrows funds at the prevailing short-term interest rates and invests its funds at the prevailing long-term interest rates, it makes a profit from the difference between long-term and short-term interest rates. During normal economic periods, long-term rates are higher and hence Chimera makes a meaningful profit. Indeed, the REIT remained highly profitable during 2014-2021, with earnings per share between $3.75 and $8.76 in every year. The only exception was 2020, which was marked by the coronavirus crisis and caused the earnings per share to plunge to $0.21. Unfortunately for Chimera, the pandemic caused a chain reaction that hurt the company severely. The U.S. government resorted to unprecedented fiscal stimulus packages to reinvigorate the economy during the pandemic crisis. Given also the impact of the war in Ukraine on the global supply of some commodities, inflation surged to a 40-year high in 2022. As a result, the Fed raised interest rates to 16-year highs last year and thus short-term interest rates have been exceeding long-term interest rates over the last two years. This paradox, which is called an inverted yield curve, is the worst possible business condition for Chimera. Indeed, the company incurred severe losses per share of -$7.53 in 2022. However, it is important to note that the rate-hiking cycle has almost certainly ended. Thanks to the drastic interest rate hikes executed by the Fed, inflation has decreased from 9.2% in the summer of 2022 to 3.3% now. As the target range of the central bank is 2.0%-2.5%, it is evident that most of the work has already been done. Indeed, the Fed is widely expected to begin reducing interest rates later this year. If inflation proves more persistent than currently expected, the Fed will probably postpone reducing interest rates. Nevertheless, it is not likely to raise interest rates. If it raises interest rates, it will cause panic to financial markets and simultaneously it will increase the interest expense that burdens the budget of the U.S. government. The annual interest expense of the government has more than doubled since 2020, and thus it has surpassed $1 trillion for the first time in history. Therefore, the Fed is extremely unlikely to raise interest rates. This is the critical part for Chimera, as its business seems to have stabilized under current interest rates, after the initial shock caused by the unexpected surge of interest rates in 2022-2023. The delinquency rate on the loan portfolio of Chimera has fallen below pre-pandemic levels while the earnings per share and the book value per share have stabilized. Financial Metrics of Chimera (Investor Presentation) Source: Investor Presentation To cut a long story short, Chimera is highly vulnerable to unexpected hikes of interest rates, which are highly unlikely for the foreseeable future, given the decrease in inflation, the guidance of the Fed and the burden of high interest rates on the budget of the U.S. government. Analysts seem to agree on this view, as they expect Chimera to recover strongly this year and remain profitable until at least 2026. More precisely, they expect the earnings per share of the company to recover from $0.39 in 2023 to $1.45 this year and grow by another 10% in 2025. The Preferred Stock of Chimera The preferred stock of Chimera comprises a material portion of its capital stock. More precisely, the REIT has total equity capital of $2.6 billion, which includes $1.7 billion of common stock and $0.93 billion of preferred stock. Overview of Chimera (Investor Presentation) Source: Investor Presentation Therefore, the preferred stock of Chimera comprises approximately 36% of its capital stock. In addition, the preferred dividends of the company have comprised just 25% of its total dividend payments in the last 12 months. This means that the financial burden of preferred dividends is just one-third of the financial burden of common dividends. In other words, whenever Chimera faces an unexpected downturn and wants to enhance its liquidity, it has ample room to boost its liquidity by cutting its common dividend, without affecting its preferred dividend. The preferred stock of Chimera pays a fixed quarterly dividend of $0.50 and thus it offers an 8.0% dividend yield when it trades at its par value of $25. However, due to the multi-year high interest rates prevailing right now, the preferred stock is trading at $21.65, i.e., at a 13.4% discount to its par value. As a result, it is currently offering a 9.2% dividend yield. When a stock offers such a high yield, most investors are afraid that a dividend cut may be just around the corner. Fears of a dividend cut may become even worse given the pressure facing the business model of Chimera due to the inverted yield curve. However, as mentioned above, the worst seems to be behind the REIT in reference to interest rates. Even better, the preferred dividend of Chimera is far safer than its common dividend. The REIT does not have the right to reduce its preferred dividend unless it first eliminates its common dividend. While Chimera has reduced its common dividend by 65% in the last two years, it recently raised its common dividend by 6%. When a company raises its dividend, it is not likely to eliminate it anytime soon. It is also remarkable that Chimera has never eliminated its dividend since its formation, in 2007. Even during the Great Recession, which was the worst financial crisis of the last 80 years and was centered around mortgage loans, the REIT kept offering a common dividend quarter after quarter. Overall, Chimera is not likely to eliminate its common dividend and hence it is not likely to cut its preferred dividend. Not only does the preferred dividend of Chimera have a wide margin of safety, but also the preferred shareholders are likely to enjoy some capital gains in the upcoming years. As mentioned above, inflation has decreased from 9.2% in mid-2022 to 3.3% now. Whenever the Fed becomes confident that inflation will revert to its target zone of 2.0%-2.5%, it is likely to begin reducing interest rates. Decreasing interest rates will provide a strong tailwind to almost all fixed-income securities, including the preferred stock of Chimera. Until March-2022, the preferred stock of Chimera was trading around its par value of $25. Whenever interest rates decrease significantly off their current 16-year highs, the preferred stock is likely to appreciate towards its par value of $25. Of course, it will be hard for the stock to return to $25, as it was trading at that price when interest rates were close to zero. On the other hand, if interest rates revert from their current level of 5.25%-5.5% to 2.75%-3.0% after 2026, as per the latest guidance of the central bank, the preferred stock of Chimera is likely to appreciate from its current price of $21.65. Overall, the preferred stock of Chimera is offering an attractive yield, with a wide margin of safety, and the potential for meaningful capital gains. Risk The primary risk factor for the preferred stock of Chimera is the adverse scenario of a rebound of inflation. In such a case, the Fed may be forced to resort to additional interest rate hikes. If this occurs, it is likely to pressure the earnings of Chimera and thus the REIT may cut its common dividend. However, even in such an unlikely scenario, while the common shareholders are likely to incur material losses and a dividend cut, Chimera is not likely to eliminate its common dividend. Therefore, it is not likely to reduce its preferred dividend. Investors should also be aware that the Fed will exhaust its means to avoid such a scenario, which would increase the interest expense of the government even further and would cause panic to financial markets. Overall, while the scenario of higher interest rates would certainly hurt Chimera and might increase the risk of the preferred dividend, it has very low odds of materializing. Final thoughts The preferred stock of Chimera has offered exceptional returns in the last 7 months but it remains attractive. It is offering a 9.2% dividend with a wide margin of safety and is likely to offer material capital gains if interest rates moderate in the upcoming years. Therefore, the stock is highly attractive for income-oriented investors.

Buy cryptocurrency

Source link

Refer And Earn Demat Account – Get ₹300 | Referral Program

Open Demat Account In Angel One For FREE