PennyMac Mortgage Investment Trust (NYSE:PMT) provides you with an upside of 25% and a dividend yield of 10%. This 35% total return seems very attractive, but you must dig deeper to look at the associated risks. Let’s see what the company does, why its attractive and the risks it carries with itself.
What it does?
PennyMac Mortgage Investment Trust (NYSE:PMT) is a hybrid mortgage REIT with investments in both Agency and non-Agency MBS. Besides, the company has investments in distressed mortgage loans. For the purpose of reporting, the company’s business is divided into two business segments; correspondent lending and investment activities.
Why it is attractive?
Like the rest of the mortgage REITs, PennyMac Mortgage Investment Trust (NYSE:PMT) is in demand for its elevated dividend yield of 10.16% on a quarterly dividend rate of $0.57 per share. The quarterly dividend rate increased after the second quarter of the current year when it paid $0.55 per share. This is despite sector wide dividend cuts in the mortgage REITs sector.
Apart from the elevated dividend yield, investors can expect capital appreciation of 25%. The stock is currently exchanging hands at $22.4 per share, against a mean price target of $27.92 per share. Therefore, the total return of around 35% seems very attractive.
The total return potential becomes very attractive especially when a large proportion of the return is coming in the form of regular dividends. Here it’s around a third of the total return.
Higher return comes with higher risk
The risk-return tradeoff dictates that high return is not without high risk. So, before the attractive total return potential in PennyMac Mortgage Investment Trust (NYSE:PMT) consumes you, you should be well aware of the risks associated with the stock.The most significant risk at this point for PennyMac Mortgage Investment Trust (NYSE:PMT) are a decline in the US home prices and the company’s portfolio credit risk. While the Fed has been busy making housing affordable by stimulating the US housing markets, the markets have shown little improvements with mixed signals puzzling the investors. The value of the loans and mortgage securities PennyMac Mortgage Investment Trust (NYSE:PMT) holds are directly linked to the underlying home prices. So, if the stimulus proves to be ineffective and the prices start declining, the fair value of PennyMac Mortgage Investment Trust (NYSE:PMT)’s loans and securities will decline accordingly. This could result in significant losses to the company, eventually hampering is dividend paying ability.
PennyMac is also exposed to credit or default risk. Since the company is exposed to the US housing sector, a home borrower default could result in a foreclosure and loss to the lender. Propagating this risk is the fact that a majority of the securities PennyMac holds are currently nonperforming and 90+ days delinquent. No due diligence can ensure that their mortgage assets and securities will perform in line with their payment and credit expectations. Therefore, any unanticipated behavior could lead to significant losses at PennyMac. Secondly, there is a possibility that none of the major credit rating agencies rate PennyMac’s assets. So, there may be lack of visibility into the credit standing of the portfolio and risk may be difficult to evaluate periodically.
Competition
In comparison, American Capital Agency Corp. (NASDAQ:AGNC) and Annaly Capital Management, Inc. (NYSE:NLY) don’t have credit risk in their portfolios as they are both exclusively invested in Agency RMBS. The Agency RMBS is back by government guarantee.
Amid speculations of QE tapering, both mREITs have seen a bloodbath and I believe the decline in the stock price will continue as speculations turn into reality. Fed’s exit will definitely increase the volatility in the interest rates and may also cause interest rates to increase and widen the Agency spread. In such a scenario, both the mREITs will face downward pressure on their book values.
However, Annaly Capital Management, Inc. (NYSE:NLY) is better positioned to produce higher income under the given situation. Annaly Capital Management, Inc. (NYSE:NLY) has positioned its portfolio in such a way that it can expand its coming quarter’s interest income by 17% if the rates climb 50 bps.
On the other hand, American Capital Agency Corp. (NASDAQ:AGNC) would see 4.3% contraction in its net interest income in a similar situation. Agency MBS spreads have widened by 18 bps in May alone to 67 bps, in line with their 20-year average. So, you can imagine the contraction American Capital Agency Corp. (NASDAQ:AGNC) will report at the end of the second quarter.
Adnan Khan has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.Adnan is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
The article 35% Total Return Potential Not Without Risks originally appeared on Fool.com is written by Adnan Khan.
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