Preferred Shares and Baby Bonds: Steady Returns in a Volatile Rate Environment

As interest rates hover near multi-decade highs, investors face a critical choice: prioritize income stability or tolerate the heightened volatility of leveraged assets. Mortgage REITs, once darlings of the dividend-seeking crowd, now struggle under the weight of rising rates and compressed spreads. Meanwhile, preferred shares and baby bonds—often overlooked for their simplicity—emerge as compelling alternatives, offering superior risk-adjusted returns in this environment. This analysis explores why these instruments are outperforming mortgage REITs like CHMI-B and RCD, and how investors can capitalize on this shift.

The Mortgage REIT Dilemma: Leverage Meets Volatility

Mortgage REITs such as Cherry Hill Mortgage Investment Corporation (CHMI) and Redwood Trust (RCD) rely on high leverage (often 5x or more) to amplify returns on interest rate spreads. In a high-rate environment, however, this strategy backfires.

Take CHMI, which reported a $9.3 million GAAP net loss in Q1 2025 due to unrealized losses on derivatives and mortgage-backed securities (MBS). While its Earnings Available for Distribution (EAD) of $0.17 per share covered the $0.15 common dividend, the 88% payout ratio leaves little margin for error.

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Similarly, RCD, which announced second-quarter preferred dividends, faces headwinds from its hybrid business model. Its price-to-book (P/B) ratio of 0.54 (as of Q3 2024) underscores undervaluation but also signals vulnerability to further rate hikes.

Preferred Shares: Steady Yields with Lower Risk

Preferred shares, by contrast, offer fixed dividends and seniority over common equity. For instance, RCD's Series B preferred shares (RCD-B) currently yield ~6.5% (floating rate tied to 3-month LIBOR), a conservative payout compared to CHMI's 20.1% common dividend but with far less volatility.

Key advantages of preferred shares include:
1. Capital preservation: Their subordination to debt but seniority over common stock reduces downside risk.
2. Predictable income: Dividends are contractual obligations, even if a company suspends common payouts.
3. Diversification: Issuers span sectors like banks (e.g., UMB Financial's redeemed Series A) and REITs (e.g., MFA Financial), spreading risk.

Baby Bonds: Fixed Maturity, Stable Returns

Baby bonds—small-par, fixed-income securities—are ideal for investors seeking capital preservation. For example, New York Mortgage Trust's (NYMT) baby bonds (e.g., NYMT-1) currently yield ~5.8% to maturity, with durations of 3–5 years. Their short maturities and fixed coupons mitigate interest rate risk compared to REITs' perpetual obligations.

A 2025 portfolio strategy might allocate 40% to preferred shares and 30% to baby bonds, with the remainder in short-term Treasuries. This structure targets a blended yield of ~5.5%–6.5% while minimizing exposure to REITs' leverage-driven swings.

Actionable Allocation for 2025

1. Prioritize seniority: Focus on preferred shares from issuers with strong balance sheets (e.g., EPR Properties (EPR) or Prospect Capital (PSEC)).
2. Match maturities to rates: Buy baby bonds with 3–5-year terms to capture current yields while avoiding long-dated interest rate exposure.
3. Avoid over-leveraged REITs: Steer clear of hybrid or commercial mREITs like Redwood Trust (RCD) unless their P/B ratios fall further.

Conclusion: Pragmatism Over Speculation

In a high-rate world, investors must trade headline-grabbing yields for sustainable returns. Preferred shares and baby bonds offer a disciplined path to income and capital preservation, whereas mortgage REITs' reliance on leverage and interest rate timing makes them risky bets. By allocating to these instruments, investors can sidestep the volatility of CHMI and RCD while still participating in the fixed-income market's upside.

The message is clear: in an era of uncertainty, simplicity wins.

This article is for informational purposes only and does not constitute investment advice. Always conduct thorough research or consult a financial advisor before making investment decisions.