Ellington Residential Mortgage REIT

NYSE:EARN

Earnings Call Transcript 2024-Q2

[Operator]

Good morning, ladies and gentlemen, and thank you for standing by. Welcome to the Ellington Credit Company 2024 Second Quarter Financial Results Conference Call. Today's call is being recorded. [Operator Instructions] It is now my pleasure to turn the floor over to Alaael-Deen Shilleh, Associate General Counsel. Sir, you may begin.

[Alaael-Deen Shilleh, executive]

Thank you. Before we begin, I would like to remind everyone that certain statements made during this conference call may constitute forward-looking statements within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not historical in nature. As described under Item 1A of our Annual Report on Form 10-K and Part 2 Item 1A of our Quarterly Report on Form 10-Q, forward-looking statements are subject to a variety of risks and uncertainties that could cause the company's actual results to differ from its beliefs, expectations, estimates and projections. Consequently, you should not rely on these forward-looking statements as predictions of future events. Unless otherwise noted, statements made during this conference call are made as of the date of this call, and the company undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Joining me on the call today are Larry Penn, Chief Executive Officer of Ellington Credit Company; Mark Tecotzky, our Co-Chief Investment Officer; and Chris Smernoff, our Chief Financial Officer. We are also joined by Greg Borenstein, Head of Corporate Credit at Ellington Management Group. Our second quarter earnings conference call presentation is available on our website, which we've recently changed to ellingtoncredit.com. Our conference this morning will follow that presentation. Please note that any references made on the call to figures in that presentation are qualified in their entirety by the notes at the back of the presentation. Furthermore, neither that presentation nor the call today should be construed as a solicitation of votes or proxies. Any such solicitation will only be made pursuant to a proxy statement or other appropriate proxy materials filed with the SEC and labeled as such. As a reminder, during this call, we'll sometimes refer to Ellington Credit Company by its NYSE Ticker, E-A-R-N or EARN for short. With that, I will now turn the call over to Larry.

[Laurence Penn, executive]

Thanks, Alaael-Deen, and good morning, everyone. We appreciate your time and interest in Ellington Credit Company. The format of our call today will be a little different from that of previous calls. I'll start by discussing highlights of the quarter as I typically do. And then Chris will describe the quarterly financial results in more detail. But after that, Greg Borenstein, Ellington's Head of Corporate Credit, will join the call to discuss EARN's CLO portfolio composition and the outlook for the CLO portfolio from here. Then our Co-Chief Investment Officer, Mark Tecotzky, will provide a brief update on our rotation out of Agency MBS. Finally, I'll wrap things up and open the floor to Q&A. Greg Borenstein has been running Ellington's investing activities in the corporate CLO sector since joining Ellington in 2012 across a wide variety of market conditions and for a wide array of Ellington's funds and accounts. We've included a short bio for Greg on slide 3. Once EARN completes its conversion to a CLO-focused closed-end fund, Greg and Mike Vranos, Ellington's Founder and Head of all portfolio management activities will officially be designated as EARN's two portfolio managers. We are all very excited to have these two veteran credit investors leading EARN's investment strategy going forward. As you can also see on slide 3, the rest of EARN's management team will remain intact. Please turn now to slide 4 of the presentation, and I'll begin with an update on EARN's strategic transformation into a CLO-focus closed-end fund. As a reminder, it was last September that we began rotating EARN's capital into CLOs. And since then, we've been steadily growing that portfolio as we approach our targeted conversion date later this year. Everything continues to go as planned. And in early July, we filed our preliminary proxy statement in anticipation of a shareholder vote at our Annual Meeting later this year. Subject to that shareholder vote, we will convert to a closed-end fund for SEC purposes, and a Regulated Investment Company, or RIC, for tax purposes, thus completing our transformation from an agency mortgage REIT to a CLO focused closed-end fund. We remain on track to complete all of these steps prior to year-end. On slide 5, we reiterate some of the anticipated benefits to shareholders of the transformation, which include better projected risk-adjusted returns over the long-term and enhanced access to capital markets. On slide 6, we summarize Ellington's long-standing experience investing in CLOs and chart the ramp-up of earned CLO portfolio. EARN acquired its first CLOs towards the end of last September. By year-end, the portfolio stood at $17 million. And by March 31, it had grown to $45 million. In the second quarter of 2024, we nearly doubled that number to $85 million. And as you can see on this slide, earned CLO portfolio is now up to about $108 million as of last Friday. At that size, CLOs now account for roughly half of EARN's total capital allocation. Meanwhile, and as planned, we've shrunk our Agency MBS portfolio significantly from $791 million last September to $531 million at June 30, and we continue to downsize that portfolio as we acquire CLOs. With that said, until we actually complete our conversion process, we must continue to hold a core portfolio of liquid Agency MBS in order to maintain our exemption from the 1940 Act. Fortunately, since we've concentrated our agency investments in liquid sectors, the cost of liquidating our agency pools to free up capital for CLOs has been very modest so far. We expect that to continue to be the case. Mark will elaborate on that later on the call. Please turn now to slide 7 of the earnings presentation for the market backdrop for the second quarter. Despite some periods of market volatility, the CLO market continued to benefit from strengthening fundamentals, robust demand for leveraged loans and continued capital inflows. Corporate loan prepayment rates increased further, reaching their highest level on a trailing 12-month basis since February of 2022. That drove further deleveraging and seasoned CLOs, which has continued to benefit EARN's holdings of discount dollar price CLO mezzanine tranches. However, as we illustrate towards the middle of this slide, the Morningstar LSTA Leveraged Loan Index actually ticked down quarter-over-quarter, following six consecutive quarters of increases. This was simply the result of those high corporate loan prepayment rates in the second quarter since many premium-priced corporate loans prepaid at par. Meanwhile, high yield and IG Credit Indices tightened further as depicted here as well. In the CLO market, you can see here that credit spreads on BB and single B CLO tranches tightened overall as well, but there were significant dispersion among deals with higher-quality tranches generally tightening and lower quality tranches widening. The European CLO market also saw spreads tighten, particularly in higher quality mezzanine tranches. For CLO equity, tightening new issue mezzanine debt spreads were a double-edged sword. On the one hand, deals with better performing portfolios and higher debt costs were able to capitalize on those tighter spreads by refinancing or resetting their debt at cheaper levels. This activity drove strong positive returns for CLO equity in those particular deals. But on the other hand, the high volume of premium priced loan collateral refinancing at par and at lower coupon spreads led, in many deals, to overall declines in net asset values and compressions in excess interest. These effects triggered mark-to-market losses for CLO equity in many deals as both the interest payments on CLO equity due to lower excess interest in the CLO and underlying asset values declined in tandem. These dynamics led to mark-to-market losses on some of earned CLO equity tranches during the second quarter. Meanwhile, in the Agency MBS market, yield spreads were a little changed quarter-over-quarter and the U.S. Agency MBS Index generated a slightly negative excess return relative to U.S. treasuries. But those minor changes belie the significant negative impact of intra-quarter interest rate volatility in generating delta hedging losses, which, for example, you've seen reflected in the weak overall performance of the Agency mortgage REIT sector this past quarter. I'll turn now to EARN's quarterly results on slide 8, and I'll begin with GAAP earnings. We had continued strong performance from our CLO mezzanine debt investments, both U.S. and European driven by both opportunistic sales and some of our discount positions being called at par. On the CLO equity side, our U.S. CLO equity investments had mark-to-market losses, driven by that heightened loan refinancing activity that I mentioned earlier. But our European CLO equity investments actually performed quite well. Overall, CLOs contributed positively to our net income for the quarter. In contrast, our remaining MBS portfolio contributed a modest $0.05 per share net loss for the quarter, caused primarily by that intra-quarter interest rate volatility. This drove our slight overall net loss for the quarter. Our ongoing rotation from Agency MBS into CLOs continue to drive our net interest margin wider, our leverage ratio's lower and our adjusted distributable earnings higher. You can see on slide 8 that our net interest margin expanded to 4.24% overall. Our debt-to-equity ratio declined to 3.7:1 at quarter end. The growth of the CLO portfolio with those wide net interest margins drove the sequential growth of our adjusted distributable earnings for the quarter. Ellington Credit's ADE grew $0.09 per share sequentially to $0.36 per share. I'll note, however, that we expect our ADE to tick down in the near-term as we continue to sell agency pools and as the associated interest rate swap hedges that we initiated in much lower interest rate environments are terminated or burn off. That said we do anticipate that our ADE will continue to cover our dividend in the third quarter. With that, I'll now pass it over to Chris to review our financial results for the second quarter in more detail. Chris?

[Christopher Smernoff, executive]

Thank you, Larry, and good morning, everyone. Please turn to slide 9 for a summary of Ellington Credit's second quarter financial results. For the quarter ended June 30, we are reporting a net loss of $0.04 per share and adjusted distributable earnings of $0.36 per share. ADE excludes the catch-up amortization adjustment, which was positive $221,000 in the second quarter. Our overall net interest margin expanded to 4.24% from 3.03% quarter-over-quarter, driven by the growth of CLOs, and that drove the sequential increase in ADE. In the second quarter, we continued to benefit from positive carry on our interest rate swaps, where we receive a higher floating rate and pay a lower fixed rate. But as Larry mentioned, we expect the impact of this benefit to decline in future quarters as some of these swaps expire and as we sell down the Agency portfolio and take off the associated hedges. Slide 10 shows the attribution of income by strategy. In the second quarter, the CLO strategy generated $0.05 per share of portfolio income, driven by strong interest income, which increased sequentially due to the accelerated amortization of market discount on several discount positions. Further, net gains on our CLO mezzanine portfolio were supported by both opportunistic sales and discount positions being called. This income was partially offset by mark-to-market losses on certain CLO equity positions where rapid prepayments drove mark-to-market losses as well as reduced floating rate spreads on the underlying loan collateral. Our agency strategy meanwhile generated a portfolio loss of $0.05 per share for the second quarter. In April, interest rates and volatility increased over renewed concerns about inflation and a more hawkish Federal Reserve, which pushed Agency RMBS yield spreads wider. In May and June, however, interest rates and volatility generally declined and Agency RMBS yield spreads reversed most of their April widening. Overall, for the second quarter, the U.S. MBS Index generated an excess return of negative 9 basis points to treasures. Against this backdrop, EARN's agency portfolio generated a small net loss for the quarter as net losses on our Agency RMBS exceeded net gains on our interest rate hedges, and that drove EARN's overall net loss for the quarter. Our non-Agency portfolio performed well during the quarter, generating $0.04 per share driven by net interest income and net gains associated with several profitable sales. In connection with our strategic transformation, we revoked the REIT election effective January 1 of this year and are currently operating as a taxable C-Corp. We came into the year with substantial net operating loss carryforwards. And in the first quarter, we used a portion of those to offset the majority of our federal taxable income. In the second quarter, our overall net loss generated a modest tax benefit and did not require the utilization of any of our NOLs. Please note that we are not booking a deferred tax asset on our balance sheet related to the NOLs so our reported book value remains fully tangible. After our conversion to a closed-end fund regulated investment company, we will generally not be subject to corporate income tax. Please turn now to our balance sheet on slide 11. Book value per share was $6.91 at June 30 compared to $7.21 at March 31. Including the $0.24 per share of dividends in the quarter, our economic return for the quarter was a negative 0.8%. We ended the quarter with $163 million in cash and unencumbered assets, of which included $90 million of U.S. Treasury bills held on margin. Next, please turn to slide 12 for a summary of our portfolio holdings. During the second quarter, our CLO portfolio increased to $85 million as of June 30 compared to $45 million as of March 31. At June 30, CLO equity comprised of 47% of our total CLO holdings, up from 25% at March 31. Meanwhile, European CLO investments comprised 17% of our total CLO holdings at June 30, up from 10% at March 31. Also during the second quarter, the size of our Agency RMBS holdings decreased to $531 million as compared to $739 million as of March 31 and our aggregate holdings of interest-only and securities and non-Agency RMBS decreased as well. Including activity through August 9, our Agency RMBS portfolio have now declined to $518 million, while our CLO portfolio has grown to approximately $108 million. As measured by allocated equity as opposed to gross assets, our capital allocation to CLOs increased to 45% at June 30 from 25% at March 31 and 11% at year-end. Our debt-to-equity ratio adjusted for unsettled trades decreased to 3.7x as of June 30 compared to 4.9x as of March 31. The decline was driven by less leverage on our CLO investments as well as higher shareholders' equity. Similarly, our net mortgage assets-to-equity ratio decreased over the same period to 4x from 5.4x. Finally, on slide 14, we provide details of our interest rate hedging portfolio. During the quarter, we continued to hedge interest rate risk primarily through the use of interest rate swaps. The overall size of our interest rate hedging portfolio declined quarter-over-quarter as the share of our portfolio and CLOs increased. As shown on slide 15, we ended the quarter with a net long TBA position, both on a notional basis and as measured by 10-year equivalents as compared with a small net short TBA position in the prior quarter. On slide 16, you can see that nearly all of the loans underlying our CLO portfolio are floating rate and as such, had much lower interest rate duration. I will now turn the presentation over to Greg.

[Gregory Borenstein, executive]

Thanks, Chris. I'm happy to be speaking to EARN's shareholders today, and I'm very excited to become your Co-Portfolio Manager with Mike Vranos going forward. I'll first talk about how we ramped CLOs and EARN over the last 10 months and then get some thoughts about how we see the portfolio evolving from here, including some thoughts on the recent volatility. Back in September, when EARN first began acquiring CLOs, CLO credit spreads were very wide. They had significantly lagged the recovery in the high-yield corporate bond market and credit spreads on certain CLO mezz tranches available in the secondary market had backed up to levels we hadn't seen since mid-2020. Meanwhile, credit fundamentals were strong and getting stronger. We saw a great risk-adjusted return opportunity in CLO mezz and started building a portfolio. Through March 31, the majority of our CLO investments were in CLO mezz. Credit spreads for CLO mezz have since tightened considerably. We've actively treated some positions to monetize gains. We've been called out of others that we held at significant discounts to par, and we also have mark-to-market gains on numerous positions that are still -- that we still hold. This dynamic has driven strong returns in EARN's overall CLO strategy so far. Fast forward to the second quarter and those tighter CLO debt spreads really enhance the attractiveness of CLO equity. Tighter new issue debt spreads lowered the implied financing cost of CLO equity, and they also enable certain CLO equity holders to refinance or reset their liabilities, which further enhances the cash flow profile of those deals from the equities perspective. For those reasons, you saw the majority of our new CLO purchases in the second quarter were in equity as opposed to mezz. And at quarter end, this led us just about 50-50 between mezz and equity. Going forward, I expect our portfolio to continue to be a blended mezz and equity with the mix fluctuating based on market opportunities. We've also supplemented our core U.S. CLO portfolio with European CLO mezz and equity investments. We've often found investment opportunities in European CLOs offer compelling relative value versus what we see in the U.S. and having an allocation to the European sector also provides some valuable portfolio diversification. Ellington has been investing in European CLOs for a decade, and I worked with our dedicated investment professionals in our London office, who analyze and trade the product day-to-day. Our investment teams in the U.S. and Europe follow the same investment processes and risk management principles and are ultimately overseen by Mike Vranos [ and me ]. In both markets, we are systematic in our evaluation of potential investment opportunities, including deep dives on credit analysis and detailed review of deal documentation and structure. Mike Vranos and I plan to continue to allocate EARN's capital to Europe opportunistically based on where we see relative value. But I expect, by and large, the majority of our CLO investments to continue to be in the U.S. As for the volatility of the past couple of weeks, while credit spreads have certainly widened overall, I'll note that markets for CLOs by and large, have been orderly even on the most volatile days as compared to some of the acute periods of panic we saw in other sectors [indiscernible] small. The volatility has created some attractive trading opportunities as it typically does, and we are able to play offense during the sell-off and deploy some of our dry powder at attractive spreads. We've also had some credit hedges in place through the recent period, which we used to help stabilize book value per share and protect against [ tail events ]. Since there's often a lag between price action on our credit hedges and price action on our assets, being able to dial up and down our credit hedges adds another dimension to potentially enhance returns. On the balance, while the recent volatility might lead some of the third quarter mark-to-market losses in part of EARN's portfolio, I also see this volatility as recharging opportunity set and providing an exciting environment for trading, which plays into Ellington's strengths. With that, I will turn the presentation over to Mark.

[Mark Tecotzky, executive]

Thanks, Greg. While Q2 is generally a good quarter for spread product, it was actually a weak quarter for Agency MBS. There was a lot of interest rate volatility to manage and continued bank portfolio restructurings added MBS supply to the market, which exacerbated volatility further. As we mentioned on last quarter's earnings call, we've laid out a clear set of priorities as we manage our investment transition from an Agency MBS focus to a CLO focus. During the quarter, we stuck to our plan and made very good progress with that transition. During the transition, while we have been focusing on acquiring attractive CLO investments, we have also been focusing on minimizing the cost of liquidating our pools, all while staying invested in the combination of Agency MBS and CLO investments that we expect to generate strong total returns and ADE in excess of our dividend. During the quarter, we shrunk our agency portfolio by nearly 30%. As we continue to sell off MBS, we are maintaining the focus on liquidity for our remaining MBS portfolio that has meant, for example, that we no longer own 15-year pools, which are typically much less liquid than 30-year pools. We also have very few Ginnie Mae pools for a similar reason. We've also reduced our pay-up risk by shedding higher pay-up pools. Our average [indiscernible] pay-up declined by over 25% in the second quarter, and that has also improved the liquidity of the remaining portfolio. Meanwhile, prepayment risk is higher now than it was earlier in the year, so we need to manage our MBS investments with that in mind as well. Like many things, the key to the plan has been execution. Despite some weak Agency MBS performance, we picked our spots, sold a meaningful part of the agency pool portfolio, and yet our MBS portfolio still almost broke even in what was a down quarter for the sector. We continue to focus on raising cash for new CLO investments while minimizing book value impairment. This process is ongoing in Q3, but things are a little different now. In the second quarter, credit spreads generally ground tighter and Greg discussed how that impacts our CLO holdings. More loans trading above par, higher voluntary loan prepayment speeds, more refinancings and more resets. But in the last two weeks, we've got a real jolt of volatility and some meaningful yield spread widening in many parts of the credit market. I think that's generally good news for us. We have dry powder and are aggressively looking to add to our holdings. A relative value approach to CLO investment often finds the best investments from the market is repricing quickly. Looking ahead, I think both portfolios are set up to deliver strong returns. A steeper yield curve and the prospect of September rate cuts is generally a good backdrop for Agency MBS, and recent widening CLO spreads should create an attractive entry point as we continue to grow our portfolio. Now back to Larry.

[Laurence Penn, executive]

Thanks Mark. The CLO strategy again outperformed Agency MBS in the second quarter as it's consistently done since EARN began investing in the sector last September. In particular, I'm pleased to have sold several CLO mezz positions and to have several discounted positions pay off at par all ahead of the recent market volatility we've seen this past week or so. These moves locked in gains when spreads were tighter, and they also freed up additional liquidity. We finished the quarter with plenty of cash and borrowing capacity to drive portfolio and earnings growth. That dry powder is particularly valuable given recent spread widening, especially in CLO equity. I really like having a targeted asset roster that includes both CLO mezzanine debt and CLO equity. Those two markets don't always perform in sync. As Greg described, we saw that in the second half of 2023, when we thought there was especially good value in mezzanine debt, more so than in equity. Therefore, when we started accumulating CLOs back then, most of our acquisitions were in mezzanine debt. And we saw this kind of dispersion again this past quarter when, as we've mentioned a few times earlier today, heightened refi activity in the corporate loan market led to stronger performance from discount mezzanine debt, but weaker performance from CLO equity. That disparate performance leads us now to see better current relative value opportunities in CLO equity rather than CLO mezzanine debt. So we've been focusing our acquisitions recently in CLO equity. Both sectors have offered high risk-adjusted returns over time, but I believe that we are able to enhance those returns even further by rotating between sectors, so as to pick better entry and exit points at each step along the way. I also like having a small but flexible allocation to European CLOs. As you can imagine, that market with its geographically distinct investor base has technical forces that can be quite disconnected from the U.S. CLO market. Again, this gives us the opportunity to further enhance returns by opportunistically deploying and rotating a portion of our capital into the European sector to both capture better relative value and improved portfolio diversification, as Greg described. We remain energized as we look forward to a successful shareholder vote at our Annual Meeting later this year, after which we can complete our conversion to a CLO focused closed-end fund/RIC. I strongly believe that our strategic transformation will generate superior risk-adjusted returns for Ellington Credit shareholders. I'm particularly pleased with how positive our conversations with investors and analysts have been following the announcement of the transformation earlier this year. With that, we'll now open the call to questions. Operator, please go ahead.

[Operator]

[Operator Instructions] And we'll hear first from Jason Weaver at JonesTrading.

[Jason Weaver, analyst]

First of all, I was curious on the dispersion on CLO performance that you noticed -- you mentioned in your prepared remarks and obviously, noting the refi activity. Is there anything else material that you can point to that's driving that performance dispersion, whether it's due to sponsor, asset class or sector concentration?

[Laurence Penn, executive]

Greg?

[Gregory Borenstein, executive]

Sure. So I think you touched upon dispersion in the assets. And if you take a look, I think you certainly see that continue to play out this year. Equity being a first loss tranche is going to be exposed to whatever happens in the tails. And you've seen this not only in leveraged loans, but in high yield, where throughout the year, you've generally seen more and more of the spread of the overall portfolio and the risk come from the widest, most credit-sensitive names. Just this morning, several series of the [ high-yield ] index had a name -- start heading down the default path. And so I think that as much as you've seen sort of macro systemic moves where liability prices have come in, which have helped improve cash flows to CLO equity and the loan prices tightening where prices have moved up, you still see a bit of dispersion deal to deal and what's going on in the tails of these portfolios.

[Jason Weaver, analyst]

Got it. Okay. And then we appreciate the update on the quarter-to-date CLO additions through last Friday. But I was wondering, can you provide a similar update on liquidity and leverage quarter-to-date?

[Laurence Penn, executive]

Looking for that number. I'm not sure we added. Leverage has ticked down. Go ahead.

[Gregory Borenstein, executive]

Sure. Yeah. So as of July 31, our debt-to-equity ratio was down to around 3x.

[Operator]

Our next question today comes from Eric Hagen at BTIG.

[Eric Hagen, analyst]

A couple of questions here. I mean how are you thinking about the dividend? Did you [indiscernible] more capital into the CLOs? And then how much more capital do you expect to maybe rotate into the CLOs just between now and, call it, the end of the third quarter?

[Laurence Penn, executive]

Yeah, I'll take the first part. Yeah, I mean, I think as we mentioned, the rotation is actually supporting our net interest margin, our ADE. So we feel good about maintaining the dividend through the conversion and thereafter. So really don't have any concerns there. Now as far as your second question, JR, you want to take that?

[JR Herlihy, executive]

Sure. So when we're in this interim period as a C-corp, we need to abide by the '40 Act exemption, as you know. So we have to maintain a core portfolio of Agency MBS, which are good assets for the '40 Act test. We updated that capital was about 50-50 between CLOs and agency as of the end of last week. We gave the gross asset amount updates. We're getting closer to the point. We're not giving exact numbers, but I think it's fair to say that -- we've said a few months ago that we plan to take CLOs over $100 million, which we've now accomplished. We're getting close to the point where we can add more on the margin, and we've been able to lower leverage, as Chris mentioned, and we've also added some more liquidity in July through asset sales. So we have more room, but certainly the pace of adding the CLO portfolio needs to subside at this point until we effectuate the conversion.

[Laurence Penn, executive]

Yeah. I think we've been adding -- I mean this is really rough, but maybe $20 million, a little over $20 million a month, something like that. And could we do that for two more months? Maybe but hopefully, this will all coincide with our conversion. So let's just -- it could be -- it could -- the timing [ could not ] be very well. But that gives you sort of an idea, I think, of where we could be heading right before the conversion. But it sort of depends on a few things structurally and it depends a little bit on how much we finance those assets. So there's a bunch of complexities. And JR mentioned whole pools are key in maintaining our '40 Act exemption all in the meantime. So we're going to continue to have that core portfolio of whole pools.

[Eric Hagen, analyst]

Okay. That's helpful. And I appreciate the outlook for the dividend to be stable. But I mean, shouldn't investors maybe expect the dividend to go higher at some point once the conversion is complete, just given the return outlook for CLOs right now?

[Laurence Penn, executive]

Love the question. I think we like to underpromise and overdeliver if we can. So we're just going to say for now, let's think in terms of maintaining.

[Operator]

And that was our final question for today. We thank you for your participation in Ellington Credit Company's second quarter 2021 financial results conference call. You may disconnect your line at this time, and have a wonderful day.