PennyMac Mortgage Investment Trust (PMT-PB)

What is PennyMac, and why does it have preferred shares?

PennyMac Mortgage Investment Trust is a real estate investment trust that buys, services, and originates residential mortgages. Like any REIT, it is required by law to pay out nearly all its taxable income as dividends, which makes it attractive to income-focused investors. PennyMac issues multiple classes of shares: common stock and several series of preferred stock. The preferred shares (such as PMT-PB) are senior in the capital structure, meaning they have a claim on dividends and assets ahead of the common shares. In exchange, they typically offer a fixed dividend rate and less upside if the company outperforms.

The preferred shares exist because they are a way for PennyMac to raise capital without diluting common shareholders as much, and because they appeal to a different investor base — those seeking stable, relatively predictable income rather than growth. As a mortgage REIT, PennyMac’s underlying business is volatile, making the fixed-dividend structure of preferreds an attractive refuge from that volatility for some investors.

How does the mortgage business generate the dividend PennyMac pays?

PennyMac’s earnings come from several streams. First, it originates mortgages and sells them into the secondary market or into mortgage-backed securities, capturing origination fees. Second, it owns a portfolio of mortgages it bought in the secondary market and holds them for yield — the spread between what the mortgage pays and what PennyMac must pay to fund it. Third, it earns servicing fees on the mortgages it services for others, collecting and remitting monthly payments and handling defaults.

All of these streams depend critically on interest rates. In a low-rate environment, origination volumes soar, but borrowers also refinance their mortgages at lower rates, prepaying the ones PennyMac holds and eroding its servicing portfolio. In a high-rate environment, origination volumes collapse, but the mortgages in PennyMac’s portfolio stay in place longer and generate higher yields. The company’s actual profitability depends on the balance of these forces, and that balance shifts unpredictably.

Preferred shares have a fixed dividend rate — say, 6% per year — regardless of what happens to PennyMac’s actual earnings. If the company’s common shares see dividends cut because origination volumes plummet or credit losses surge, the preferred-share dividend continues (until PennyMac’s earnings are so depressed that the company cannot pay it, an extreme scenario). That cushion makes preferred shares safer than common shares during business downturns.

However, preferred shares do not offer unlimited protection. If PennyMac’s earnings fall so severely that the company cannot pay its preferred dividend, the preferred shareholders are in trouble — they have a claim ahead of common shareholders, but that claim is worthless if there is nothing to claim. In a severe housing downturn with large credit losses, preferred shares are at risk too.

Why would interest rates matter so much?

Interest rates affect PennyMac’s business in two opposite ways. When the Federal Reserve cuts rates, origination volumes surge (more borrowers want to refinance and buy homes), which is good for near-term earnings. But the same falling rates cause existing borrowers to refinance, prepaying their mortgages, which shrinks the portfolio and the servicing portfolio that generates ongoing fee income. Conversely, when rates rise, origination volumes collapse (fewer borrowers refinance or buy), which is bad for near-term earnings. But the rising rates leave the existing portfolio intact and allow it to compound at higher yields — good news eventually, unless rising rates tip the economy into recession.

A rapid, sustained rise in rates is the nightmare scenario. Originations collapse, the portfolio no longer earns higher yields (because the company has no money to deploy), and defaults begin to rise as unemployment climbs. Credit losses mount, common dividends are cut sharply, and preferred dividends are at risk too. A sharp drop in rates is better (the portfolio does not grow, but it does not crater either), until it persists long enough that the portfolio completely turns over to mortgages at lower yields.

What is refinance risk, and why is it different from credit risk?

Credit risk is the chance that a borrower stops paying and the mortgage goes into default. Refinance risk is the opposite: it is the certainty that when rates fall enough, borrowers will prepay the mortgage early to lock in lower rates. Both are losses for PennyMac, but they operate on different timescales. A default might happen gradually (the borrower misses payments, then defaults a few months later). A refinance wave happens fast (rates drop, and half the portfolio prepays in the next quarter).

For a mortgage REIT, refinance risk is often more dangerous than credit risk, because it is faster and more predictable — it is not a possibility but a near-certainty in a falling-rate environment. And unlike credit losses, which might happen only in severe downturns, refinance losses hit in the best scenario for most borrowers (lower rates mean cheaper mortgages).

What happens to preferred shares if the company cuts its dividend?

Preferred shareholders have priority in receiving dividends ahead of common shareholders, but that priority is conditional on the company having earnings to pay out. If PennyMac’s earnings collapse and the board cuts the dividend to preserve capital, preferred shareholders take the cut along with (or before) common shareholders. The fixed rate is a promise, not a guarantee. Historically, mortgage REITs that have faced severe downturns have occasionally suspended or cut preferred dividends, a traumatic event that typically causes the preferred share price to fall sharply.

That said, cutting the preferred dividend is a last resort — it signals severe distress and is extremely damaging to the company’s reputation and future financing. Management has strong incentive to cut common dividends and retain more capital before cutting preferred dividends.

How does PennyMac’s leverage affect the preferred shares?

PennyMac borrows heavily to fund its mortgage portfolio, using both repo financing and securitised debt. That leverage amplifies returns in good times — a small amount of equity is used to control a much larger portfolio of mortgages, which is a way to increase the return on equity. But leverage amplifies losses in bad times. If credit losses mount or refinancing shrinks the portfolio faster than expected, the company’s equity cushion (common and preferred) erodes quickly.

A highly leveraged firm is also vulnerable to funding shocks. If the repo market or securitisation market freezes (which happened in 2008 and again briefly in 2020), the firm might not be able to refinance its debt and could be forced to sell mortgages into a falling market, locking in losses. That scenario would destroy both common and preferred share values.

How to research PennyMac preferred shares

Read PennyMac’s 10-K (SEC CIK 0001464423) to understand the terms of each preferred series — dividend rate, redemption price, and ranking. Watch the company’s quarterly earnings for trends in origination volumes (rising or falling?) and the weighted-average coupon of the mortgage portfolio (are older, higher-yielding mortgages staying in the portfolio, or are they being refinanced out?). Track the loan-loss reserve and any provision for credit losses — are defaults expected to rise? Monitor the company’s leverage ratio and its access to funding markets; if repo rates spike or securitisation windows close, the company’s profitability compresses immediately. Finally, pay attention to any commentary on the preferred dividend coverage ratio — does management believe the company has sufficient earnings to pay all preferred dividends? If doubt creeps in, the preferred share price will fall before the dividend is cut.