Ellington Credit Co Q4 FY2023 Earnings Call

Good morning ladies and gentlemen. Thank you for standing by and welcome to the Ellington Residential Mortgage REIT 2023 Fourth Quarter Financial Results Conference Call. Today's call is being recorded and at this time, all participants have been placed in a listen-only mode. The floor will be open for questions following the presentation. It is now my pleasure to turn the conference over to Alaael-Deen Shilleh, Associate General Counsel. Sir, you may begin.

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 and 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. We strongly encourage you to review the information that we have filed with the SEC, including the earnings release and the Form 10-K for more information regarding these forward-looking statements and any related risks and uncertainties. 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 Residential; Mark Tecotzky, our Co-Chief Investment Officer; and Chris Smernoff, our Chief Financial Officer. As described in our earnings press release, our fourth quarter earnings conference call presentation is available on our website, earnreit.com. Our comments this morning will track to the presentation. Please note that any references to figures in this presentation are qualified in their entirety by the notes at the back of the presentation. With that, I will now turn the call over to Larry.

Thanks Alaael-Deen and good morning everyone. We appreciate your time and interest in Ellington Residential. As with much of 2023, in the fourth quarter, markets gyrated between a selloff and a rally with tumultuous October giving way to a market rally in November and December. In October, interest rate volatility spiked as U.S. treasury yields rose to 15-year highs and that drove yield spreads sharply wider on most fixed income products. Markets then reversed course in anticipation of the conclusion of the Federal Reserve's hiking cycle, with interest rates and volatility both declining into year-end. With rates lower, and trading in a more stable range, demand for spread products picked up and capital flowed into fixed income funds. With the notable exception of CMBS, which has its own unique challenges, virtually all fixed income spreads tightened for the fourth quarter, including in the markets where EARN invests, namely Agency and non-Agency RMBS and now corporate CLOs, where we've been investing to an ever-increasing extent after our recent pivot. Turning to the investor presentation. On Slide 3, you can see that medium and long-term interest rates, despite spiking to multiyear highs in October, actually declined overall for the quarter. And the 30-year Freddie mortgage survey rate despite reaching a 23-year high mid-quarter also finished lower on the quarter. Incredibly, despite all of the fluctuations during the year, both the 10-year treasury yield and the 30-year mortgage survey rate finished 2023 within 1 basis point of where they started the year, as you can see here on this slide as well. As the backdrop for our mortgage-backed securities portfolio, you can also see on Slide 3 that option-adjusted yield spreads tightened across agency coupons during the fourth quarter and that the most pronounced price increases were on lower and intermediate coupons. Dollar prices on Fannie 2.5s through 4.5s were up more than 5 points sequentially. The outperformance of those coupons benefited EARN's Agency MBS portfolio specifically because coming into the quarter, roughly two-thirds of our Agency MBS had coupons of 4.5% or less. Meanwhile, as the backdrop for our CLO portfolio, corporate credit spreads followed a similar pattern, first widening in October and then tightening in November and December and tightening overall for the quarter as an economic soft landing narrative permeated the market. You can see on the bottom of Slide 3 that credit spreads on both high yield and investment-grade tightened significantly over the quarter, while prices on the Morningstar LSTA Leveraged Loan Index rose. Turning now to EARN's results. In the fourth quarter, we generated net income of $0.75 per share and a non-annualized economic return of 7.7%, while our adjusted distributable earnings grew to $0.27 per share and more than covered our dividend. As with other market disruptions we've seen before, the key in the fourth quarter was to avoid forced selling when the market sold off in October in order to preserve equity and earnings power and be in a position to participate in the subsequent market recovery. In the fourth quarter, we again relied on EARN's risk management and strong liquidity position to accomplish this. That said, we did sell pools in the fourth quarter to free up capital from MBS to CLOs and the majority of our sales took place in November as yield spreads were tightening. We ended up increasing the size of our CLO portfolio by $13.6 million during the quarter. On Slide 12 of the earnings presentation, you can see some of the underlying characteristics of our CLO portfolio as of year-end. The corporate loans underlying our CLO investments span a diverse array of industries and the overwhelming majority are floating rate first lien senior secured loans. Our rotation into CLOs has continued into the new year with our agency portfolio now incrementally smaller and the size of our CLO portfolio now up an additional 70% from year-end to approximately $30 million. Even after the recent credit spread tightening in the sector, we still see returns on equity for new CLO investments in the high teens to low 20s. Besides contributing to and diversifying EARN's GAAP results, our high-yielding CLO investments have also helped drive the substantial growth of our net interest margin and thereby have supported our ADE as well. In addition, because we employ less leverage on our CLOs compared to Agency, the portfolio rotation has also driven down our leverage ratios. At year-end, our debt-to-equity ratio adjusted for unsettled trades declined to 5.3:1, down from 7.3:1 at September 30th.

Thank you, Larry and good morning everyone. Please turn to Slide 5 for a summary of Ellington Residential's fourth quarter financial results. For the quarter ended December 31st, we reported net income of $0.75 per share and adjusted distributable earnings of $0.27 per share. AD excludes the catch-up amortization adjustment, which was positive $566,000 in the fourth quarter. During the quarter, positive net interest income and net gains on our Agency MBS significantly exceeded net losses on our hedges, driving strong performance from our agency portfolio. Our CLO portfolio also generated strong returns, driven by net interest income and net gains as did our non-Agency RMBS and interest-only portfolios. On Slide 5, you can see that our overall net interest margin expanded to 2.19% from 1.34% quarter-over-quarter, which drove the increase in ADE. Broken out by product, our agency NIM increased to 2.02% from 1.26%, driven by higher asset yields and a lower cost of funds. Meanwhile, our credit NIM, which includes CLOs and non-agency RMBS, increased to 6.28% from 4.55%, boosted by high asset yields on our larger CLO portfolio. Please turn now to our balance sheet on Slide 6. Book value per share was $7.32 at year-end compared to $7.02 per share at September 30th. Including the $0.24 per share in dividend in the quarter, our economic return for the quarter was 7.7%. We ended the quarter with $61 million in cash plus unencumbered assets, which was approximately 45% of total equity. Next, please turn to Slide 7 for a summary of our portfolio holdings. Our Agency RMBS holdings decreased by 8% sequentially to $728 million as of December 31st as net sales and paydowns exceeded net gains. Our Agency MBS portfolio turnover was 25% for the quarter. Our aggregate holdings of non-Agency RMBS and interest-only securities also shrunk in size by 13% quarter-over-quarter. Over the same period, we increased our CLO holdings more than fourfold to $17.4 million as of December 31st compared to $3.8 million as of September 30th. At year-end, our deployed equity was allocated 89% to mortgage-related securities and 11% to CLOs. Our debt-to-equity ratio adjusted for unsettled trades decreased to 5.3 times as of December 31st as compared to 7.3 times as of September 30th. The decline was primarily due to an increase in shareholders' equity and a significantly lower leverage on the CLO portfolio relative to our agency holdings. Similarly, our net mortgage asset-to-equity ratio decreased to 6.5 times from 7.2 times over the same period despite our holding a net long TBA position at December 31st as compared to a net short TBA position at September 30th. On Slide 9, you can see the 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. We ended the fourth quarter with a net long TBA position on a notional basis, but a small net short position as measured by 10-year equivalents. Lastly, on Slide 12, you can see that nearly all of the loans underlying our CLO portfolio are floating rate, and as such, carry minimal interest rate risk.

Thanks Chris. The fourth quarter was really a tale of two markets. The first part of the quarter was characterized by continued rate sell-off, wider spreads, fund outflows, and market uncertainty about how high the Fed would need to hike short rates before achieving a noticeable improvement on inflation. But then starting in late October and early November with economic indicators and comments from Chairman Powell pointing to a possible end to the rate hike cycle, markets started to make a U-turn. Rates dropped, spreads tightened and there was a significant fund in bank buying of Agency MBS and other spread products. In Agency, sector outperformance in the second part of the quarter exceeded underperformance in the first part. And overall, for the quarter, Agency MBS significantly outperformed hedging instruments. I'm happy to report that EARN is well-positioned to capture this Agency outperformance, posting a total economic return of almost 8% for the quarter. During the market sell-off in the first part of the quarter, we were able to manage the interest rate volatility and keep our Agency MBS portfolio largely intact. We were confident that it was just a matter of when, not if spreads will recover, and maintaining our portfolio allowed us to capitalize on the spread tightening when it did eventually occur. During Q4, the market pivot and Fed expectations was the catalyst that led to lower implied and realized volatility, which lowered actual and expected hedging costs and prompted capital inflows from banks and investment funds. If and when the first rate cut occurs later this year, we think that could be another catalyst for continued outperformance for Agency MBS. We were able to take advantage of the market strength to shrink our Agency MBS portfolio incrementally and redeploy that capital into CLOs. That rotation not only enhanced our diversification, but it also took our leverage down significantly, and yet we were still able to grow ADE. In Q4, our CLO portfolio grew by $13.6 million as we predominantly added seasoned CLO mezzanine tranches, but also longer-duration CLO equity, shorter-duration CLO equity, and newer vintage CLO mezzanine. Seasoned mezzanine investments outperformed throughout Q4 as prepayment speeds accelerated and CLO cash balances grew, driving expectations of a deal deleveraging in January, and that strong performance has continued into 2024. CLO credit spreads tightened across the board in Q4 with BBBs generally rallying around 30 to 50 basis points and BBs rallying even more, albeit with significant dispersion. However, these sectors lagged the high-yield corporate bond market, whereby some measures, spreads tightened by almost 100 basis points for the quarter. Q3 earnings were better than expected for many high-yield borrowers with JPMorgan estimating that 86% of high-yield companies generated Q3 earnings that were either neutral or positive for their credit profiles. Investors generally grew more comfortable with non-investment-grade credits in Q4 as fundamentals improved. Improvements in the leveraged loan market drove strength in junior CLO tranches given that they are more leveraged to credit performance than senior tranches are. This said, the most credit-sensitive CLO profiles, that is those with the lowest credit enhancement and/or most of the stressed portfolios, continued to lag as investors anticipated further credit losses. In Q1 of 2024, we anticipate further strengthening our CLO portfolio due to declining credit market zest and continued pull to par in seasoned CLO mezzanine. Approximately 40% of the leveraged loan index traded above par at the end of Q4, which has incentivized lots of borrowers to refinance their debt so far in 2024. This is benefiting both seasoned CLO mezzanine to faster deal paydowns and CLO equity to lower near-term default risk as underlying corporate borrowers raise incremental liquidity. We also expect the technical backdrop for the leveraged loan market to remain attractive as many new CLOs are expected to ramp up portfolios in Q1, driving demand for loans with a forward calendar of loan supply that remains light. Looking ahead, we see lots of reasons to be optimistic about EARN's future performance. The most aggressive Fed hiking campaign ever is now behind us. SOFR went from 0% to over 5% in 14 months. The Fed balance sheet has shrunk by well over $1 trillion since its peak post-COVID size. Coupled with large bank failures, putting almost $100 billion of Agency MBS and CLOs into the market, you had the recipe for substantial spread widening, which we've seen over the past couple of years. But now the Fed should soon become a tailwind as opposed to a headwind. And looking ahead, in addition to this expected support from the Fed, we see five major factors supporting future MBS performance. First, spreads are wide. Not as wide as October but still much wider than historical averages, and they should be, with the Fed as a seller, not a buyer, and banks while buying are a shadow of their former selves. But being wide and staying wide works out just fine for EARN; we have a big levered net interest margin to capture. Second, supply is low, and it's especially low relative to the mountain of Treasury supply. So, relative performance versus hedging instruments are supported by this technical. Third, prepayment risk for most coupons is benign, and the cost of prepayment protection is reasonable. Fourth, flows into mutual funds that buy Agency MBS, both active and passive, have been quite strong as have fixed income annuity sales. Banks have also started to buy in Q4. And fifth, volatility is a lot lower, both actual and implied, so delta hedging costs are lower, and that makes option-adjusted spreads wider. We have room to add leverage at EARN. We have tools to further grow ADE and CLOs are helping to deliver a diversified return stream.

Thanks Mark. I was pleased with how we navigated the market gyrations throughout 2023 and finished the year on a high note. Now, with yield spreads still wide on a historical basis with markets expecting cuts instead of hikes and with volatility normalizing, Agency MBS are attracting incremental demand from investors, albeit tempered by uncertainty around the timing of cuts. When those rate cuts eventually come and we ultimately see a steep yield curve again, that should be a further tailwind to the sector. I'm excited about our growing corporate CLO portfolio. EARN's small size and liquid portfolio has been an advantage this year as we've been able to ramp up quickly in a terrific strategy where we see a big opportunity for EARN. While Ellington has long-standing and deep experience managing CLO portfolios, EARN began investing in that product just this past September, and that pivot is already contributing nicely to earnings. Including investments through today, CLO investments are now a full 17% allocation of EARN's total equity. I expect them to be a significant driver of earnings and ADE moving forward. The CLO market has proven its ability to generate attractive returns over market cycles and over a long-term horizon. In the short term, and as Mark mentioned, credit spread tightening in some segments of the CLO market has continued to lag a larger rally in corporate bond credit spreads, and we expect that money manager inflows into high-yield and leveraged loans will help narrow that gap. As Mark also mentioned, we expect faster leveraged loan prepayment speeds to drive faster prepayments on many of our seasoned CLO mezzanine positions, which we hold at significant discounts to par. We've grown EARN's CLO portfolio by another 70% so far in 2024, and these discounted seasoned CLO mezzanine positions have continued to be a focus of ours, given their total return potential in an environment with this potential for higher loan prepayment speeds. The CLO market suits EARN extremely well. It not only offers high current interest income, but it has always been a fertile ground for both relative value and absolute value opportunities as well as for trading opportunities given the dispersion in collateral credit performance from deal to deal. Going forward, Ellington's extensive expertise and track record in the CLO market should be a big benefit for EARN. Our CLO portfolio has continued to contribute nicely to our results so far in 2024. But net losses in Agency MBS have led to an overall economic return for EARN that we currently estimate at negative 1.9% year-to-date through February. The Agency MBS market has underperformed many other fixed income sectors so far in 2024, driven by higher rates and uncertainty around the timing of Federal Reserve rate cuts. This, of course, follows a strong fourth quarter for Agency MBS, which led to the positive 7.7% non-annualized economic return that we generated last quarter. For the past few years, it's undeniable that Agency MBS has been a volatile strategy for all the agency mortgage REITs, including EARN. But I firmly believe that our CLO strategy will prove to be a less volatile strategy and thereby stabilize and enhance EARN's returns over time. And with that, we'll now open the call to questions. Operator, please go ahead.

Thank you. Our first question will come from Doug Harter with UBS. Please go ahead.

Thanks. Can you talk a little bit more about how you see the equity allocation to CLOs playing out, kind of how much of equity could this be?

Yes. Hey Doug, how are you? I’m not going to answer that question directly, but I want to express my support for the strategy. We have a strong team and an impressive track record. The more we can do, the better, in my view. As you know, we operate under certain constraints as a REIT, which primarily focus on income and capital allocation, but these also depend on our financing strategy and subsidiary structure. We continue to grow, and I prefer not to predict where this will lead.

Okay. And then I guess just as you think about risk-adjusted returns kind of comparing Agency and CLOs. How do you think about kind of the upside, downside in each kind of the base case and kind of how that factors into kind of where you want to be?

Sure. First, regarding the net interest margin, the NIM on our Agency portfolio is likely in the low 200s, while the credit portfolio, including CLOs, is in the 600s. Even with minimal leverage, the CLO portfolio provides a higher leveraged NIM on a dollar-for-dollar basis. Spreads have tightened, and looking back at our slides, you can see the differences based on the coupon. For instance, looking at 4.5s, the ZSpread is around the 90 to 100 level by year-end, but even with significant leverage, it doesn’t quite match the CLO portfolio on a leverage basis. It's important to note that the CLO portfolio does carry tail credit risk, especially in the event of a deep recession. This is a significant consideration. Additionally, it has lower delta hedging costs. The large fluctuations in the market over the last few years have posed challenges for Agency REITs like us, as we prefer to hedge against interest rates. Over time, these delta hedging costs can reduce book value and ultimately impact dividends. On a trading front, the liquidity of Agency assets offers more opportunities for trading profits. For example, if one could hypothetically make a point on assets by timing additions or subtractions in hedging, leveraging that could result in a substantial increase in earnings. Each sector has its pros and cons, and there are trading opportunities in CLOs as well, but those assets are generally less liquid. I appreciate the strategy and am eager to see CLOs grow as much as possible.

I appreciate that. Thank you.

And our next question will come from JMP. Please go ahead.

Hey good morning everybody. Hope, everyone's doing well. First question, I guess, is, did I hear correctly that you said book value was down about 1.9% thus far this year? Was that total economic return?

Total economic return.

Okay, cool. Thank you.

Yes, I think that was through the end of February.

So, including the two dividends, what leverage ratio range are you targeting moving forward, considering the significant decline that the leverage ratio experienced in the fourth quarter? Is there a specific level you're aiming for?

It's really about finding the right level of leverage for each asset class. For Agencies, we've previously increased leverage into the 9s. For non-Agencies and CLOs, we've maintained almost no leverage, but we plan to add leverage to the CLO portfolio eventually. As I mentioned earlier, you can comfortably expect about half a turn return to leverage on CLOs. The strategy will depend on capital allocation. In Agencies, while we can reach that upper limit of around 9:1 leverage, we also have the flexibility to go lower. We sometimes do this to take advantage of spread volatility, allowing us to buy low and sell high throughout the year.

Thank you for that. I have another question. This is more of a long-term inquiry. What are your thoughts on the kind of interest rate environment it would take to see a significant increase in prepay speeds back towards the historical levels we observed a few years ago?

Mark?

We received the prepayment reports last night, and it's worth noting that while overall prepayment speeds have remained stable, advancements in technology, particularly AI, are being adopted by some major non-bank lenders. There are segments in the market, such as certain Ginnie pools, that are showing prepayment speeds over 80 CPR, especially from high coupon loans with significant VA backing. However, the vast majority of loans still require a couple of hundred basis points drop in rates to become refinance-able. Many of the coupons we own have considerable room before they reach that threshold. Additionally, obtaining prepayment protection isn't costly, and mortgage bankers will actively seek out refinancing opportunities when feasible. Nevertheless, the majority of the market we own would need a significant rate reduction for refinancing to become viable. Despite the unpredictability of rates and high implied volatility, we continue to opt for pools with prepayment protection, considering them reasonably priced. Last year, we focused on identifying specified pools with faster-than-market projected prepayment speeds, which allowed us to enter into favorable positions with 2.5s, 3s, and 3.5s. Even small increases in prepayment speeds can greatly enhance yield. While prepayment modeling and risk remain pertinent, the concerning prepayment speeds are currently impacting only a limited number of loans, a sector we've chosen to steer clear of. It's not surprising to observe these rapid prepayment speeds due to the remaining capacity in the mortgage banking sector and improved technology. We anticipate that they will remain proactive as opportunities for refinancing arise.

Got you. Thank you, Mark. And as always, best of luck guys going forward. Thanks.

Thank you.

And our next question will come from Matthew Erdner with JonesTrading. Please go ahead.

Hey guys. Thanks for taking the question. Kind of following up on that CPR, you guys took off some of the lower coupons during the quarter. Could you kind of talk to the thoughts there?

Yes, during the quarter we identified opportunities to increase our coupon rates. The portfolio saw a rise of about 10 basis points in coupon. The performance of lower coupons compared to current coupons is significantly influenced by flows into major bond indices. In the mortgage index, for example, the distribution of mortgage coupons within indices like the Barclays Aggregate is heavily oriented towards 2s and 2.5s. Consequently, the relative performance of those coupons is greatly affected by the flows into those types of portfolios where lower coupons tend to outperform. We took the opportunity to increase our coupon rates, believing it would not only enhance our average daily earnings but also contribute to total return. We plan to remain opportunistic in pursuing this strategy.

That's helpful there. And then allocating capital to CLOs, continuing that strategy. Are there any other places where you feel like you guys could opportunistically deploy additional capital for total return?

That's where we're focusing on now, no.

And our next question will come from Eric Hagen with BTIG. Please go ahead.

Hey thanks. Good morning. Hope everyone is well. One more on just kind of the market dynamics. I mean what do you feel like would support more dollar roll specialness in the market? Do you feel like it's reasonable to expect that, that could come back if there's any changes to Fed policy?

I would say that for the higher coupon rates, dollar rolls have predictably weakened due to an increase in faster-paying pools. For example, with Fannie 6 now in production for a few months, some pools have reached the seasoning stage. Therefore, I don’t expect to see significant specialness. In the lower coupons, specialness can occur with substantial flows. Previously, I mentioned the importance of aggressive indices; when money enters such an index, the manager might want to purchase Fannie 2s and 2.5s to reduce tracking error. This means acquiring bonds from other investors, as primary dealers initially buy from them but will seek to replenish their inventory from other portfolios. Many of those bonds are currently held by the Fed and banks. Recent news concerning Truist affected lower coupons negatively. Consequently, the lower coupon sector may experience more volatility in the rolls. However, if you are selective with fast-paying pools, you might identify pools that enhance carry against the roll. I don't foresee much specialness ahead for higher-end production coupons, which are trending towards faster floats. As for lower coupons, there can be specialness, but it tends to vary month by month; for instance, a month ago, the Ginnie 2, 3 roll was special. These occurrences are sporadic, and I believe the primary production areas won't show much specialness, which contrasts sharply with 2021 when Fannie 2s and 2.5s frequently exhibited specialness due to heavy purchasing by the Fed and banks. That situation is not present now. Thus, the current rolls suggest a preference for more specified pools and fewer TBA trades. Overall, this reflects a shift in the industry, particularly within the REIT sector.

Yes, that's a good perspective. As far as running the portfolio, I mean, what do you guys feel like as a minimum level of liquidity you feel comfortable with having it at these spread levels? Like how much do you feel comfortable with ahead of the Fed cut versus like a cut actually taking place? Do you feel like that would be a catalyst to carry more leverage? Or is it potentially conditional on other factors?

We mentioned earlier that there are predictions for cuts this year, and I believe when they actually occur, it could lead to some incremental buying, which would be beneficial. Regarding our cash management, it remains a priority, and we will manage it based on market conditions and the repo roll calendar without changing our minimum cash levels based on the Fed's actions. This approach is how we operate EARN, EFC, and our private funds, as we maintain a certain amount of cash on hand. We assess our portfolio, leverage, and potential shocks to determine our cash needs. Additionally, with the Agency matters, there’s a calendar aspect involved. We receive new factors when prepayments occur, affecting repo lenders and margin calls, but the actual cash doesn’t come in until the 25th. While we have the capacity to add leverage, our cash management strategy remains unchanged. This method has been effective for us over a long time, particularly during stressful periods like COVID. Furthermore, EARN has abundant liquidity and continues to invest in CLOs while still having the capacity to leverage its general pool strategy.

Yes. Hey, thank you guys so much.

Thank you, Eric.

And that was our final question for today. Thank you for participating in the Ellington Residential Mortgage REIT fourth quarter 2023 earnings conference call. You may disconnect your line at this time and have a wonderful day.