Ellington Residential Mortgage REIT

NYSE:EARN

Earnings Call Transcript 2024-Q3

[Operator]

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Credit Company 2024 Third 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. 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 again joined by Greg Borenstein, Head of Corporate Credit at Ellington Management Group. Following the completion of our conversion to a CLO closed-end fund, Greg, along with Ellington's Founder, Mike Vranos, will officially be designated as EARN's 2 portfolio managers.

Our third quarter earnings conference call presentation is available on our website, ellingtoncredit.com. Our comments this morning will follow that presentation. Please note that any references made on this call to figures in that presentation are qualified in their entirety by the notes at the back of the presentation. Any figures relating to the current status of the shareholder vote are made as of this morning.

Such figures are subject to change based on a variety of factors, including the ability of shareholders to change or revoke their votes, which they are entitled to do at any time prior to the annual meeting and our tabulator of finalizing its report. 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. I'll start with an update on the shareholder vote related to our strategic transformation. As you've seen, we have postponed the Annual Shareholder Meeting as we work to accumulate the required votes to approve the conversion of EARN to a Delaware closed-end fund. Shareholders' support for the conversion has been overwhelmingly positive.

Based on voting results as of this morning, the 3 conversion-related proposals have approval rates above 92% and over 95% if you don't include abstentions. However, in order to pass 2 of the 3 proposals, we need for votes from a majority of all shares outstanding, not just of votes cast. And as of this morning, we are still short of that threshold.

On those proposals, we currently have about 10.5 million for votes, but we still need a little more than 2 million additional for votes in order for them to pass. I should note that these approval rates are unofficial and preliminary, and shareholders can change their vote at any time prior to the annual meeting. Both ISS and Glass Lewis, the leading independent proxy advisory services, have unanimously recommended for votes on all the conversion-related proposals as they recognize the benefits to EARN's shareholders of the conversion.

On Slide 4, we highlight 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 the capital markets, while also affording shareholders with the additional protections provided by the 1940 Act.

Furthermore, as a registered investment company, we would generally not be subject to corporate income tax. With our current status as a taxable C-Corp, we are subject to a small level of corporate income tax, but we will be subject to the full corporate tax level after our NOLs burn off. Also, until we convert to a RIC, we also need to continue to hold a portfolio of Agency MBS pools to maintain our exemption from the 1940 Act, and thus, that keeps us from completing the full transition of our investment portfolio to corporate CLOs.

To those who have voted already, thank you. And to those with unvoted proxies, please submit your vote as soon as possible.

Please turn now to Slide 6 of the earnings presentation for the market backdrop for the third quarter. Despite volatility spiking in early August, the CLO market in the third quarter continued to benefit from strengthening loan fundamentals and robust demand for leveraged loans. As you can see on this slide, leveraged loan default rates continue to decline in both U.S. and Europe, while prepayment rates continue to be elevated, particularly in the U.S.

In terms of new CLO issuance, while tightening credit spreads and lower interest rates supported strong corporate loan issuance, net CLO supply in the U.S. was actually negative overall for the quarter as a result of the combined impact of an elevated pace of refinancings and resets and as many seasoned CLOs were called. Also, as depicted on Slide 6, the combination of strong loan fundamentals and positive market technicals during the quarter drove CLO mezzanine spreads tighter overall in both U.S. and European markets, while high yield and IG credit indices tightened further as well.

Similar to the prior quarter, performance for U.S. CLO equity was somewhat mixed, which Greg will get into later on this call. Meanwhile, in the Agency MBS market, with interest rates falling and the yield curve steepening in anticipation of the Fed's cut in September, Agency MBS spreads tightened, and the U.S. Agency MBS index generated an excess return of 76 basis points for the quarter.

I'll turn now to EARN's third quarter results on Slide 7. We had another quarter of excellent performance from our CLO debt portfolio, with robust loan prepayments triggering further deleveraging in our seasoned mezzanine positions and with low default rates boosting demand for junior mezz tranches, which drove credit spreads tighter.

We also enhanced returns in our CLO debt portfolio through some opportunistic trading, and we further enhanced returns by driving the liquidation of a CLO where we own discount mezzanine debt. In that case, the redemption proceeds we received upon the CLO's liquidation far exceeded the value of our mezz debt position were it to have remained as a CLO tranche. Meanwhile, we also had positive performance in our CLO equity portfolio, also enhanced by opportunistic trading as well as by our successful completion of 2 deal refinancings.

Finally, we had positive results from our remaining RMBS investments, and EARN's overall annualized economic return for the third quarter was 10.8%. As with prior quarters, our ongoing shift from Agency MBS into CLOs continue to lower our leverage ratios. You can see on Slide 7 that our debt-to-equity ratio declined to 2.5:1 at quarter end. Meanwhile, our cash plus unencumbered assets finished the quarter at a very healthy $121.5 million, which represented nearly 2/3 of our total equity.

The wide net interest margins on our CLOs also enabled our adjusted distributable earnings to continue to cover our dividends during the third quarter, despite our significantly lower leverage and even as we terminated in conjunction with selling Agency pools several interest rate swap hedging positions that had been supporting ADE. As we had forecast on last quarter's call, our ADE did tick down in the third quarter as we terminated these swaps. But as we had also forecast, our ADE for the third quarter still exceeded our first quarter level of $0.27 per share and covered our third quarter dividends.

With that, I'll now pass it over to Chris to review our financial results for the third quarter in more detail. Chris?

[Christopher Smernoff, executive]

Thank you, Larry, and good morning, everyone. Please turn to Slide 8 for a summary of Ellington Credit's third quarter financial results. For the quarter ended September 30, we are reporting net income of $0.21 per share and adjusted distributable earnings of $0.28 per share. ADE excludes the catch-up amortization adjustment, which was positive $173,000 in the third quarter.

Our debt-to-equity ratio, adjusted for unsettled trades, decreased to 2.5x at September 30 compared to 3.7x at June 30. The decline was driven by higher shareholders' equity and the less leverage we employ on our growing CLO investment portfolio as compared to the leverage we employ on our legacy Agency MBS portfolio. Similarly, our net mortgage asset-to-equity ratio decreased over the same period to 3x from 4x.

Our overall net interest margin increased to 5.22% from 4.24% in the prior quarter, which reflects the higher allocation of capital to the credit strategy and a higher NIM on our agency portfolio driven by higher asset yields and a lower cost of funds. Despite the overall increase, the net interest margin on our credit portfolio actually declined sequentially, finishing more in line with our first quarter NIM.

As we highlighted last quarter, the higher NIM in the second quarter has been the result of accelerated prepayments on the loans underlying several discounted CLO positions, which resulted in high payoff activity and high asset yields for those CLO positions. Prepayment activity was less significant in the third quarter in our CLO mezz portfolio, which drove asset yields and NIM in the credit portfolio more in line with our first quarter results.

In the third quarter, we continue 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, the impact of this benefit declined in Q3 as some of these swaps expired and as we sold down the Agency portfolio and took off the associated hedges.

While the swap benefit should continue to burn off as we finish our rotation out of Agency MBS and into CLOs, the wide NIMs of the CLOs themselves are a counterbalance. The combination of lower leverage and the swap terminations drove the sequential decline in our ADE. Despite the decline, our adjusted distributable earnings continued to exceed our dividends paid in the third quarter.

Slide 9 shows the attribution of income by strategy. In the third quarter, the CLO strategy generated $0.12 per share of portfolio income, driven by strong net interest income, which increased sequentially with the larger CLO portfolio. Further, net gains on our U.S. and European CLO debt portfolios were supported by both opportunistic sales and tighter credit spreads on held positions.

We also benefited from positive performance from our U.S. and European CLO equity portfolios, where net interest income exceeded net realized and unrealized losses. The net realized and unrealized losses in CLO equity were primarily the result of dollar price and NIM compression on the corporate loan assets underlying our CLOs, partially offset by the positive impact of opportunistic trading and the 2 deal refinancings that Larry mentioned.

Meanwhile, our Agency strategy performed well in the third quarter, generating $0.18 per share of portfolio income. In the quarter, interest rates fell, the yield curve steepened and Agency MBS spreads tightened as the market anticipated at the beginning of the Federal Reserve's interest rate cutting cycle.

In September, the Federal Reserve reduced the target range for the federal funds rate by 50 basis points and also released updated economic projections that implied another 50 basis points of interest rate cuts later in 2024, although that expectation is no longer shared by the market.

Tighter yield spreads drove net gains on our Agency RMBS, which exceeded net losses on our interest rate hedges, driven by declining interest rates. Our non-Agency portfolio generated positive results for the quarter as well driven by net interest income and net gains associated with several profitable sales.

As a reminder, in connection with our strategic transformation, we revoked our REIT election effective January 1 of this year, and we are currently operating as a taxable C-Corp. We came into the year with substantial net operating loss carryforwards. And in the third quarter, we used a portion of those to offset the majority of our federal taxable income, and we intend to continue to do so for so long as we operate as a C-Corp.

For the third quarter, we accrued an income tax expense of $463,000, which represents the net tax liability accrued on our taxable income after the NOL offset. Due to federal and state restrictions on NOL utilization, we cannot offset 100% of our taxable income.

Our utilization of NOLs reduced our effective tax rate from what would have been about 28% to about 7.8% for the quarter. 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 the conversion to a closed-end fund/RIC, we generally will not be subject to corporate income tax.

Please turn now to our balance sheet on Slide 10. Book value per share was $6.85 at September 30 compared to $6.91 at June 30. Including the $0.24 per share of dividends in the quarter, our economic return for the quarter was 2.6% or 10.8% annualized with compounding. We ended the quarter with $121.5 million of cash and unencumbered assets.

Next, please turn to Slide 11 for a summary of our portfolio holdings. Our CLO portfolio increased to $144.5 million at September 30 as compared to $85 million at June 30. At September 30, CLO equity comprised 52% of our total CLO holdings, up from 47% at June 30. Meanwhile, European CLO investments comprised 17% of our total CLO holdings at September 30, consistent with the prior quarter.

Our capital allocation to CLOs increased to 58% at September 30 from 45% at June 30. Meanwhile, the size of our Agency RMBS portfolio decreased to $462 million compared to $531 million at June 30. And as you can see on Slide 12, we are entirely out of 15-year pools. Cost to liquidate our Agency RMBS continue to be low, and our remaining Agency RMBS portfolio is very liquid. Our aggregate holdings of interest-only securities and non-Agency RMBS decreased as well to less than $12 million.

On Slide 13, we provide details of our interest rate hedging portfolio. During the quarter, we continue to hedge interest rate risk primarily through the use of interest rate swaps. As shown on Slide 14, we again ended the quarter with a net long TBA position, both on a notional basis and as measured by 10-year equivalents.

On Slide 15, you can see that nearly all the loans underlying our CLO portfolio, our floating rate and as such, has much lower interest rate duration. We also selectively hedged the credit risk of our corporate CLO and non-Agency RMBS investments. As of September 30, 2024, our credit hedge portfolio was relatively small.

Finally, general and administrative expenses were higher quarter-over-quarter due to expenses incurred related to the strategic transformation. Management fees were also higher quarter-over-quarter, driven by higher shareholders' equity at quarter end.

I will now turn the presentation over to Greg.

[Gregory Borenstein, executive]

Thanks, Chris. It's a pleasure speaking to everyone again today. As Larry mentioned, performance of our CLOs in Q3 was led foremost by our debt portfolio, where tightening mezz spreads offered opportunities to monetize gains and also drove positive price action on assets that we continue to hold.

As the market has continued to tighten, we have looked to trade out of debt positions where we think the total return upside is largely played out. We are still selectively finding opportunities in mezz paper, but some of the low-hanging fruit is gone. And we are very focused on appropriate risk-adjusted returns and avoiding reaching for yield by taking on undue risks.

We also had positive performance in our CLO equity portfolio in the quarter, albeit with a lower ROE than our mezz portfolio. Overall, in the market, the performance of CLO equity was more of a mixed bag, as tightening credit spreads on both leveraged loans on the asset side and CLO debt tranches on the liability side produce some more nuanced results.

On one hand, tightening debt spreads allowed some deals to refinance or reset their debt, including extending their reinvestment periods. And that drove strong returns from many CLO equity profiles in deals with better-performing portfolios and higher debt costs.

On the other hand, higher prepayment speeds in the loan market led to both price declines for loans trading above par and compression in loan floating rate spreads as large volumes of loans trading at premiums to par were refinanced at par and replaced with lower-spread loans. These effects triggered mark-to-market losses in some CLO equity profiles as both their interest payments due to lower excess interest in the CLO and underlying asset values declined in tandem.

We saw a similar dynamic play out in Europe, although with slower prepayment speeds, the negative impact of the prepayment of premium loans was less pronounced. As we look to the remainder of the year, we currently see better relative value and ample opportunities in CLO equity, where tighter debt spreads are improving economics for both new and existing deals.

Early signs post election are showing general spread tightening in the credit markets, which, accompanied with higher rates, have continued to improve demand for floating rate CLO liabilities. In addition, continued heavy issuance in the CLO market is creating inefficiencies and relative value opportunities in both CLO debt and equity. Given our strong systems and deep experience in both primary and secondary markets, EARN is well positioned to capitalize on these inefficiencies.

With that, I turn the presentation over to Mark.

[Mark Tecotzky, executive]

Thanks, Greg. Q3 was generally a strong quarter for spread products. Both CLO debt and Agency MBS performed well relative to benchmarks as the Fed kicked off its interest rate cutting cycle in September.

Looking at Agency prepayments, we are predicting that -- we have been predicting that newly issued non-call-protected pools could have elevated prepayment rates if they get in the money, and that is exactly what happened in the third quarter when rates fell. We saw CPRs north of 60 for certain Fannie Mae pools with mid-7s WACC. Fortunately, for EARN, we have largely protected our Agency portfolio from that type of exposure.

Looking back over the past 12 months, I am really happy that we were able to put so much money to work in the CLO market at wider spreads than current levels. In the third quarter, we stayed invested in our core holdings of Agency MBS, while also selling down that portfolio, as needed, to free up cash for additional CLO purchases. By quarter end, nearly 60% of our capital was allocated to CLOs.

However, until we complete EARN's conversion to a RIC, I'll note that our ability to increase our CLO capital allocation much above that 60% level is limited by the requirement to stay exempt from the 1940 Act, which requires us to maintain that core portfolio of Agency pools. So from here, we will stay largely invested in the current MBS portfolio until the conversion occurs, capturing the available Agency NIM, and we'll only really be net selling MBS to add CLOs to the extent we have room.

Meanwhile, we've continued to make our Agency MBS portfolio incrementally more liquid. And once we obtain the requisite approvals for the conversion, we will sell down our remaining Agency MBS portfolio and complete the rotation to CLOs. We've seen long-term interest rates, including mortgage rates, rise substantially since quarter end. That has had a chilling effect on origination volumes, which are also poised for the typical seasonal slowdowns.

In addition, the third quarter brought the first Fed rate cut in 4 years, and we just had another cut last week, so we should soon see our first noninverted yield curve in a while. All these factors should increase demand for MBS from banks and CMO arbitrageurs and create a favorable supply-demand technical for Agency MBS going into year-end.

Now back to Larry.

[Laurence Penn, executive]

Thanks, Mark. I'm pleased with the continued ramp-up and strong performance of the CLO strategy in EARN and how we've pivoted our CLO portfolio composition as the market opportunity has evolved. I'm particularly pleased with the active approach we've taken to enhance our returns. Our active approach not only includes the opportunistic trading that is a core tenet of our portfolio management philosophy, but it also can include driving refinancing and/or liquidation of the deals we're invested in when beneficial and achievable. All these steps have added alpha to our results.

So far in the fourth quarter, we've continued to see the benefits of the portfolio rotation away from Agency MBS and towards CLOs, with CLOs returning positive returns in October even as volatility and interest rates rose. Those market movements drove Agency spreads quite a bit wider in October, but they've somewhat retightened in November post election.

We very much look forward to completing our RIC conversion. I strongly believe that our strategic transformation will generate superior risk-adjusted returns for Ellington Credit shareholders. If you haven't voted yet, please do so. And as always, we are happy to answer any questions. I continue to be encouraged by how positive our conversations with investors and analysts have been following the announcement of the transformation earlier this year.

And with that, we'll now open the call to questions. Operator, please go ahead.

[Operator]

[Operator Instructions] And we will take our first question from Crispin Love with Piper Sandler.

[Brian Vescio, analyst]

This is Brian Vescio on for Crispin. Just kind of high level, can you speak on the credit quality in the CLO book and how you expect that to trend over time? Kind of what are your delinquency and loss expectations as well as risk-adjusted returns?

[Gregory Borenstein, executive]

Sure. I think, overall, longer term, if rates -- if we go through, for example, it's scenario-dependent, a very high rate environment for a long time, that will clearly stress corporate credit and some of these companies' ability to be able to service their debt. I think, in general, you see the current trailing 12-month default rate is below 1%. Historically, it may sit 2 north above that. If you take a look at COVID, this got to, at the peak, a little over 4%.

And so that gives you a sense of some of the things that we've seen in both benign and stressed environments. We don't have a crystal ball, but I would say that you could certainly see them elevate from where we are now into that more traditional average if we stay in a higher rate environment. And how we think about the credit quality, I think, overall, if things get tighter in the market and spreads are tighter, it allows more companies to have access to financing and perhaps you see looser documentation, which is something we look at.

If things start to get more stressed, you're going to see the market be a little bit more buyer-friendly with perhaps tighter language, more covenants and only better-quality companies coming to market. And so it's a little bit of balance in terms of how we see that progressing, if that answers it.

[Brian Vescio, analyst]

Yes, I appreciate the commentary. And then just the last question for me. How do you guys think about the dividend, especially as you rotate more capital on the CLOs and leverage continues to tick down?

[Gregory Borenstein, executive]

Sure.

[Laurence Penn, executive]

Yes. Well, as we rotate it -- I can take that. .

[Gregory Borenstein, executive]

Go ahead.

[Laurence Penn, executive]

I mean, yes, as we're rotating into CLOs, yes, the leverage is ticking down, but our net interest margin is going up quite quickly. So our -- and as I mentioned, our adjusted distributable earnings for the third quarter were in line, maybe even $.0.01 higher, than they were back in the fourth quarter.

So we don't see -- at this point, we see good support for the dividend through our adjusted distributable earnings, and we've already rotated -- gone from basically 0% if you go back a little over a year of CLOs to now, I think, as we mentioned before, over half of our capital is -- risk capital is now in CLO. So less leverage, but greater net interest margin, and the 2 seem to be balancing out pretty well. So our dividend is still well supported as we continue this rotation.

[Operator]

And we will take our next question from Douglas Harter with UBS.

[Douglas Harter, analyst]

You guys were active in raising capital through the ATM during the quarter. Can you talk about kind of your continued appetite to do that?

[Laurence Penn, executive]

Yes. I mean, Chris, do you want to talk about kind of our execution there in terms of was there any dilution?

[Christopher Smernoff, executive]

Sure. Yes. During the quarter, there was $0.04 of dilution. We also expect that, that slight dilution will reflect in better G&A ratios going forward.

[Laurence Penn, executive]

Right. So that will be -- at those levels, it's very accretive to earnings because we raised a fair amount of capital. So I would say, look, our stock price now is not in a place where we would tap the ATM. But when we were trading much higher in the third quarter, we took advantage of it. And so it's going to be very price dependent at this point. And if we're raising capital as we did, net very close to book, that is -- given that we're a small company and that we do have fixed expenses, I mean, it's -- I think it's a no-brainer.

[Operator]

And we will take our next question from Jason Weaver with JonesTrading.

[Jason Weaver, analyst]

Maybe 1 for Greg, just on the visibility. I think you touched on this in your prepared remarks. Would you expect the strong issuance trend to remain in place if pricing remains supportive? Any sort of nuance or cadence implications over the next few quarters ahead that you can suss out?

[Gregory Borenstein, executive]

So I think on the trend we're heading and what we see in the market right now, I -- this was a very large issuance year. You saw a lot of resets. I think you will continue to see that. Taking a step back, AAAs have come in. They're starting to get close to levels that were close to the post-financial crisis types.

I think with demand for floating rate products, especially from maybe some traditional places that didn't wait CLOs as much, I think with what happened in 2022, you see places very focused on rate duration with perhaps where that is headed. That, in addition to the growth of the CLO ETF space at the top of the capital structure, this should keep putting demand pressure on CLO liabilities. As that happens, as deals will exit their non-call, you will see the equity investors, which control the option, continue to come to market.

And you may also see actual new issuance deals continue to pick up with loan creation also turning back on. That was a bit of a -- that's sort of what's slowed things down last year. It was hard for people to simply source the loans. That's why it was a lot of recycling or resetting, if you will.

But just talking to a lot of the banks that we work with and actually bank these transactions, everyone seems like they have a busy pipeline ahead. And getting to these levels, which we have not seen since a couple of years before COVID in that '17, '18 time frame, a lot of deals will still find it additive to come in and reset their liabilities.

[Jason Weaver, analyst]

Got it. And then maybe related to it, exactly, assuming today, if you had certainty about the shareholder vote being supportive, to liquidate the Agency portfolios seems relatively straightforward. But what does the time line look like to move that capital into new CLO equity?

[Gregory Borenstein, executive]

Sure. So I think we're obviously watching it carefully. And so as we see the probability increase there, we will behave accordingly in terms of how much dry powder we want to keep in terms of leaning into that a little bit. I think that, overall, be realistic. The tighter the market is, the more patient and selective we are about our investments.

If things were dislocated, that would obviously present a real opportunity, and we could go into secondary and purchase CUSIPs pretty quickly. That said, I think with -- EARN is left in a very diversified place right now. And so we're fortunate to not be too worried about concentration risk. And so I think that if we start to see that move forward, as noted in the prepared remarks, we really see the value in new issue.

And so I think we would simply be more active with where we see that opportunity, coming in with new issue and sort of setting up those types of transactions to rotate the rest of the portfolio and get going on that. And as we said, it's very, very busy. And so with all the banks working on deals and all the volumes coming out, I think we would just lean into that opportunity more.

[Jason Weaver, analyst]

Excellent. That's very helpful.

[Laurence Penn, executive]

Yes. I mean, I think, just sorry to follow up on that. Right at the end of the quarter, we had $145 million of CLO investments, up from $85 million a quarter before, and that's without having the push of the shareholder vote already done and sort of ready, as you said, to liquidate the remaining pools and reinvest.

So -- and our -- so that's -- in 1 quarter, that's $60 million, and that's without pedal to the metal. And our equity capital, as you can see, is under $200 million. So we could be invested, certainly, in a quarter or less equal to our total capital base, our total equity base.

And I think we could do it even faster. Now of course, we want to have some leverage in the portfolio. So I think 90 days is a very reasonable target. But of course, we're not there yet. We need the votes.

[Operator]

Thank you. That was our final question for today. We thank you for participating in the Ellington Credit Company Third Quarter 2024 Financial Results Conference Call. You may now disconnect your line at this time, and have a wonderful day.