Penny Mac Mortgage Investment Trust , a mortgage REIT with a 15% dividend yield, just announced that it has approved plans to buy back up to $150 million worth of its own stock, which happens to be trading at a steep discount to book value. While there are numerous risks that come along with an investment in a mortgage REIT, this strategy could be the safest way to make money for shareholders.
PennyMac: a different kind of mortgage REITUnlike most mortgage REITs, which buy mainly rock-solid agency guaranteed mortgages, PennyMac primarily invests in distressed mortgages. Since PennyMac can purchase distressed mortgages at a discount to the value of the underlying properties, the company doesn't need to use as much leverage as its peers. In fact, while most of the sector-leading mortgage REITs use leverage of five-to-one or more, PennyMac's leverage ratio is currently 3.2-to-one.
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In addition to the distressed mortgages, PennyMac invests in mortgage servicing rights (MSR), which serve as an excellent hedge against rising interest rates. When rates rise, fewer people refinance (prepay) their mortgages, hence mortgages need to be serviced for longer periods of time and MSRs can generate more fee income -- making them more valuable. PennyMac has been investing in MSR assets lately, which could protect shareholders and potentially even increase profits if rates suddenly rise.
Source: PMT company presentation
The business model seems to be working. Over the past several years, other mortgage REITs have been forced to slash their dividends, and shareholders have experienced large declines in the value of their holdings. In contrast, PennyMac has actually increased its dividend by 45% over the past five years, and although the share price has dropped a bit, the company has produced a total return of 63% for shareholders who decided to reinvest their dividends. Take a look at how that compares with the returns of Annaly Capital, arguably the most popular mortgage REIT in the sector.
Why the buyback is an excellent ideaPennyMac's buyback may seem a little ambitious. As of this writing, the $150 million buyback program represents just over 9.2 million shares, or more than 12% of the total. When a company plans to buy shares back this aggressively, it's because it believes the capital will be put to better use with buybacks than reinvested into the business.
It's not difficult to see why PennyMac's management might feel this way. At the current share price ($16.29), PennyMac is trading at a discount of more than 20% to its book value ($20.39). So every time PennyMac buys back a share of its stock, it receives an immediate $4.10 profit -- at least on paper.
If the company uses the entire $150 million buyback, this translates to a "profit" of $37.7 million. Now, keep in mind that this won't be an actual profit, but the collective book value of the remaining shares should theoretically increase by this amount.
PennyMac assigns a "target" return on equity ranging from 11% to 18% for its core business activities, so with an opportunity to earn a 20% instantaneous return without its usual risks, an aggressive buyback seems like a no-brainer.
A great yield and solid management, but beware of the risksSpeaking of risks, while I applaud this latest decision by PennyMac's management, investors should be aware of the risks involved.
First of all, all mortgage REITs are somewhat sensitive to interest rates. PennyMac does a fantastic job of hedging against sudden rate increases, but if interest rates were to experience a dramatic swing one way or the other, shares could get hurt.
PennyMac is well-protected against rising interest rates. In this graphic, the red line represents the company's net sensitivity to rate changes. Source: Company presentation
And, although PennyMac uses significantly lower leverage than most other mortgage REITs, a 3.2-to-one leverage ratio does create a substantial amount of risk. Not only that, but PennyMac borrows money to finance the purchase of distressed mortgages, which inherently makes the company more vulnerable to default risk. If another real estate crash comes and a wave of defaults and foreclosures takes place, the value of PennyMac's mortgage assets could plunge.
The bottom linePennyMac is my personal favorite mortgage REIT (I've been a shareholder for some time now), and I applaud the decision to aggressively repurchase shares at a discount. However, this is not a low-risk investment by any definition of the word, and investors should be aware of this fact before considering PennyMac for their portfolio. If you have the necessary appetite for risk, PennyMac could generate serious income for your portfolio, and the upcoming buybacks could create some upside potential in the share price as well.
The article This Ultra-High Dividend Stock Is Buying Back Its Shares at a Discount originally appeared on Fool.com.
Matthew Frankel owns shares of PennyMac Mortgage Investment Trust. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.