PennyMac Mortgage Investment Trust (PMT) is a mortgage real estate investment trust, or mREIT. They own some mortgage-backed securities and some mortgage servicing rights.
Preferred Shares
We are discussing PennyMac today because of the preferred shares. There are three preferred shares from PennyMac. They are PMT-A (PMT.PR.A), PMT-B (NYSE:PMT.PR.B), and PMT-C (PMT.PR.C).
The most interesting shares are PMT-A and PMT-B. However, I will also touch on PMT-C briefly.
PMT-C is a fixed-rate preferred share. That means the dividend rate does not change. As long as the company is paying the preferred share dividend, it will be the same set amount.
Dividend Priority
If a mortgage REIT were to suspend their preferred share dividend, they would also have to suspend the common share dividend. They would need to repay all the preferred share dividends that accrued during that period before they could resume paying common share dividends.
That can be an intriguing clause because the company is required to pay the preferred share dividend in full. It is my opinion that PennyMac is failing to pay their preferred share dividend in full for PMT-A and PMT-B. To be clear, I am not a lawyer or a judge. I am not rendering a legal opinion on the matter. I am giving you my opinion as a financial expert who has thoroughly researched this case and invested in the PennyMac preferred shares.
Fixed-to-Floating Not Fixed-to-Fixed
PMT-A and PMT-B are fixed-to-floating preferred shares according to the prospectuses. That means they start with a fixed dividend rate and then transition to a floating dividend rate. PennyMac announced in 2023 that the LIBOR Act caused their fixed-to-floating shares to become fixed-rate shares. They provided very little explanation on how they reached this interpretation of the law.
It seems obvious to me that this interpretation is directly contrary to the stated purpose of the law. The purpose of the law was to reduce uncertainty about what would happen with the cessation of LIBOR. Every mortgage REIT apart from PennyMac determined that the proper response to the act was to utilize SOFR as a replacement for LIBOR. Specifically, this would be SOFR plus 26.161 basis points.
When PennyMac made their announcement, I spent a substantial chunk of time going through the terms for each preferred share, so I could provide an assessment on each share for our subscribers. There were a few shares with terms that seemed questionable under PennyMac’s interpretation of the law. However, all of those shares have since been resolved by management explicitly indicating that they would use SOFR. If you want to see more analysis on why they must use SOFR, please refer to my prior articles.
Lawyers Suing PennyMac
If there was any doubt about my interpretation, then it would be useful to know that other people have concurred, specifically lawyers who are now suing PennyMac for their actions. PennyMac is no stranger to court. They have lost other cases before. They are fighting what I consider to be a stupid battle. The evidence is absolutely overwhelming. There is no logical basis for PennyMac’s interpretation. I believe that is why PennyMac refrained from explaining their interpretation at any point. To the best of my knowledge, they have still failed to explain how they were able to reach the conclusion that a fixed-to-floating share would become a fixed-rate share. There are scenarios where that could happen, but I could not find a reasonable interpretation of their prospectus that would lead me to that conclusion.
Some analysts have argued that PennyMac must be right. Their argument was occasionally based on not understanding English, and sometimes simply assuming that anything any management team ever does must be right.
I have a term for people who view management that way, but it is inappropriate to use on Seeking Alpha. I believe those people tended to expect other preferred shares to also switch from a fixed-to-floating rate to a fixed-rate security. However, I would remind investors that no other mortgage REIT came to the same conclusion. Every other mortgage REIT with fixed-to-floating shares announced that their contracts would shift to using SOFR + 26.161 basis points in accordance with the LIBOR Act.
PennyMac’s Side of the Story
It is important to share both sides of the story. You should also hear PennyMac’s side. Therefore, I am including management’s impeccable (that was sarcastic, it’s trash in my view) explanation from the day PennyMac announced their decision:
PMT Press Release, Notes by Author
There isn’t really any logic there that explains how they reached the decision. Disregarding the polling provisions doesn’t cause the rates to remain fixed.
Conclusion
Based on the floating spread, the prospectuses, and the LIBOR Act, I believe the dividend yield on these preferred shares would increase substantially if PennyMac honors the prospectus as I interpret it. In the scenario where interest rates plunge dramatically, the floating rate would be unfavorable. However, investors who expect interest rates to plunge dramatically should be looking at long-term bonds (preferably very high credit quality) instead of fixed-to-floating preferred shares.
I understand and respect the fact that some investors will simply choose not to own anything associated with PennyMac after evaluating management’s behavior. I am still willing to pursue the investment case, but I completely respect investors who decide to avoid the company for their decisions.
Presently, shares are priced at about the right level.
They were cheap many months ago, cheap again about two months ago, and briefly cheap a few weeks ago.
Shares trade discounted to call value (about $24.50 today, including nearly a full quarter of dividend accrual) because there is still a case going on. If PMT pulled out a miracle victory and overturned every reasonable interpretation of the English language, it would push prices down. If PMT’s defense gets tossed in the dumpster like memorabilia from a Justin Bieber concert, shares should trade above $25.00 to account for the higher yield.
In our subscriber sheets, we have the “buy under” price target currently set at $24.53. That includes dividend accrual. Given that shares are only a few pennies from that, I decided to just tag the article with a neutral rating.
The stripped yield using the old fixed-rate dividend is 8.32%. However, if PMT updates the dividend in accordance with the floating rates, it would be around 11.79%. That’s a big difference. For these calculations, I only used the $.50/quarter rate that PMT agrees they owe. I’m just trying to keep it simple.
For more discussion of preferred shares, see my guide to investing in preferred shares.
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