Redwood Trust Preferred A: 10.87% Fixed-To-Floating Yield With Upside (RWT.PR.A)


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We earlier published a report on what we see as a strong growth trajectory for Redwood Trust (RWT). While we have long been aware of RWT’s presence in the jumbo mortgage market, we only revisited it because of Portfolio Income Solution’s ongoing search for the best opportunities in the Fixed-to-Floating rate preferred space. What we were first looking at was RWT’s recently issued Redwood Trust Inc. Series A Reset Rate Cumulative Redeemable Preferred (RWT.PR.A) (RWT.PA).

The Issue

Like other mREITs and holders of fixed income securities, RWT’s book value was buffeted in last year’s rapidly rising interest rate market. Common book value declined 21% from $12.06 at fiscal year-end 2021 to $9.55 at fiscal year-end 2022; the common prices were discounted from there. Looking around at the disarray in the banking sector, Redwood wanted fresh capital to take advantage of any opportunities that might arise but issuing common stock was prohibitively expensive. Undeterred, management likely swallowed hard before deciding to issue $70MM of Series A preferred stock with a whopping 10.0% face coupon in January of 2023.

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Portfolio Income Solutions

RWT.PA becomes callable at a $25 par value on 04/15/2028. If the shares are not redeemed their coupon is reset at the then 5-year T Note yield + 627.8 basis points. As the Portfolio Income Solutions Fixed-to-Floating table describes, at today’s 5y yield, the interest rate would reset at 10.69% as measured against par or 11.62% against today’s $23.00 market price.

Considerations for Investment

Calendar

With a conversion/rate-reset date almost five years out, you need to consider where you stand on the “higher for longer” debate. Is the 10.87% going in yield (fixed for almost 5 years) the most attractive option available? Or would it be more profitable to buy an issue with a nearer term conversion date, like PMT.PA, where the rate begins to float toward an 11.5% yield in just eight months? The decision tilts heavily in consideration of your personal calendar.

Coupon

A furtherance of the “higher for longer” debate would include consideration of what happens to the yield curve over time. If we find the economy has gone into recession, the Fed might be moved to begin reducing interest rates. In that trend, the floating rates linked to short-term SOFR (PMT.PA) would see its yield begin to decline. If at the same time the yield curve would reverse its current inverted state, the floating rates linked to longer-term 5-year Treasuries (RWT.PA) might hold steady or even rise from today’s rates.

Cost

In addition to the dividend income, a meaningful investment consideration is upside to call/redemption. In the examples we are using here, PMT.PA has about $1/share upside (4.2%) from today’s market price to its potential redemption in March 2024. RWT.PA has about $2/share upside (8.7%) from today’s market price to its potential redemption in April 2028. Because markets are dynamic, price changes can expand or shrink potential returns.

The Issuer

Redwood Trust has been around since 1994 and though it operates multiple lines of business, its broader reputation identifies with its long history of origination, funding, and securitization of jumbo residential mortgages. Our earlier RWT article describes our renewed enthusiasm about their opportunities in today’s jumbo mortgage market.

RWT’s common equity market capitalization of $892MM and common book value capital of $1.06B are 12.7X and 15X the size of the RWT.PA $70MM liquidation preference. This capital should be more than sufficient, after debt service, to fund RWT.PA’s $7MM annual dividend.

Trading

As we noted earlier, RWT.PA was issued in January of this year and this is the record of its trading thus far. With only 2,800,000 shares outstanding and just a few thousand shares changing hands daily, Redwood preferred A would be accurately described as a thinly traded issue.

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2MC/Yahoo Finance

Over the last couple of months, the shares have settled into a price range of $22.50 to $23.75, but that may be more related to the issue’s obscurity and not a measure of its value. At $23.00, the shares can be bought for a yield 100 to 300 basis points higher than that of a small mREIT preferred peer set. The difficulty for current shareholders is that it can only be sold for a yield 100 to 300 basis points higher than that of small mREIT preferred peer set: the seller’s supply faces insufficient buyer demand to drive share prices higher. We think we saw the same new issue phenomenon with EFC.PC and AGNCL and gap will be resolved with seasoning.

A New Alternative for a Dynamic Fixed Income

Over the last year, in the face of a seemingly inexorable rise in interest rates, we have tried to identify fixed-to-floating REIT preferreds that would accommodate both rising yields and principal protection. Redwood Trust Series A preferred is a compelling value at a discount to par and differentiated from other variable rate preferreds as the only issue focused on the niche market of jumbo mortgage investment. We are long both Redwood Trust common and preferred.



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