Ellington Credit Co Q1 FY2025 Earnings Call

Good morning, everyone. Thank you for joining us. Welcome to the Ellington Credit Company First Quarter 2025 Financial Results Conference Call. This call is being recorded. I will now hand it over to Alaael-Deen Shilleh, Associate General Counsel. Please proceed.

Thank you. Before we begin, I'd like to remind everyone that this conference call may include forward-looking statements within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements are not historical in nature and involve risks and uncertainties that are detailed in our most recently filed annual report on Form 10-K and our filed but not yet effective registration statement on Form N-2. Actual results may differ materially from these statements, so they should not be considered to be predictions of future events. The company undertakes no obligation to update these forward-looking statements. Joining me today are Larry Penn, Chief Executive Officer of Ellington Credit Company; Greg Borenstein, Portfolio Manager; Mark Tecotzky, Executive Vice President; and Chris Smernoff, Chief Financial Officer. Our earnings call presentation is available on our website, ellingtoncredit.com. Today's call will track that presentation, and all statements and references to figures are qualified by the important notice and end notes at the back of the presentation. With that, I'll turn the call over to Larry.

Thanks, Alaael-Deen. And good morning, everyone. We appreciate your time and interest in Ellington Credit Company. I am very pleased to report that on April 1st, we successfully completed our conversion to a registered closed-end fund. As planned, within days of the conversion, we quickly and efficiently sold our remaining agency mortgage pools and covered our TBA short positions, all with minimal impact on our net asset value. In fact, even with all the market gyrations in early April, we estimate that these pool liquidations had only about a $0.01 per share effect on our net asset value. This $0.01 effect was exactly what we had estimated on our last earnings call and it was the precise and well-timed hedging by Mark Tecotzky and his team that made this excellent result possible. As a byproduct of our conversion to a closed-end fund, we also changed our fiscal calendar to begin on April 1st. Therefore, on today's earnings call, when we refer to the quarter ended March 31, 2025, to avoid confusion, we'll refer to that quarter as calendar Q1. Okay. So now to our calendar Q1 results. During calendar Q1, in preparation for the conversion, we increased our CLO portfolio by 46% to $250 million, while we kept the size of our long agency mortgage portfolio stable in order to maintain our exemption from the 1940 Act right up to the point of conversion. Also, starting in January, we aggressively ramped up our TBA short mortgage hedges. And so when volatility began to spike in March, we had already completely neutralized our exposure to the mortgage basis, thus saving us from the losses that we would have incurred when spreads widened later in the quarter. This positioning also enabled our agency mortgage portfolio to significantly outperform during those volatile periods leading up to and through our final sales in early April. Turning to Slide 4. Let's take a look at the market backdrop for the quarter. A strong January and February gave way to turbulence in March as investor sentiment soured on fears of tariffs, slowing growth, and inflation persistence. Interest rate and spread volatility surged in March, equity indices declined and credit spreads widened, including in the CLO market, where both mezzanine debt and equity tranches saw meaningful price declines. You can see in the middle of Slide 4 that spreads on high yield, investment grade, and CLO debt tranches widened and therefore, prices declined across the board during the quarter, with most of that occurring in March. Importantly, the price declines we saw were a function of potential future credit concerns, especially for companies that will be impacted by skyrocketing tariffs and not the result of any current or near-term credit concerns. Let's now move past quarter end and into early April. After selling all our mortgage pools following the conversion, our liquidity and buying power increased significantly and we got to work ramping up our CLO portfolio. Our timing was fortunate as we were able to add very attractive assets during all the April market turmoil. More recently, significant tariff deescalations have led to credit spreads and prices reversing course in May, retracing a significant portion of the March and April move. It was great to be able to put fresh cash to work in CLOs while prices were lower. To sum up calendar Q1, while our Agency mortgage strategy delivered positive results for the quarter, declining prices on CLO mezzanine debt and equity drove an overall net loss. Nevertheless, our adjusted distributable earnings continued to cover our dividends for the quarter, and we've seen prices come back strong so far in calendar Q2. I'll turn it over to Chris now to walk through some more of the financial details.

Thanks, Larry. And good morning, everyone. Please turn to Slide 5. For calendar Q1, we reported a net loss of $0.23 per share and adjusted distributable earnings of $0.26 per share. Our overall net interest margin increased by 20 basis points to 5.27%, supported by our growing capital allocation to CLOs. On Slide 6, you can see portfolio P&L by strategy, which was negative $0.24 per share from CLOs and positive $0.08 from agency. In our CLO portfolio, mark-to-market losses exceeded net interest income and modest gains on our credit hedges. In our agency portfolio, net gains on agency RMBS exceeded net losses on interest rate hedges for the quarter. At March 31st, our book value per share was $6.08 and combined cash and unencumbered assets totaled $169 million or 74% of total shareholders' equity. Our economic return for the quarter was negative 3.2%. Our debt-to-equity ratio adjusted for unsettled trades declined to 2.2 times at March 31st, down from 2.9 times at December 31st. Over the same period, our net mortgage asset to equity ratio decreased to about zero from 2.6 times, driven by a net short TBA position that almost entirely offset our Agency RMBS holdings at quarter end. Slide 9 shows our CLO portfolio increasing by 46% to $250 million at March 31st and capital allocated to CLOs expanding to 81% from 72% at December 31st. At March 31st, CLO equity comprised 66% of our total CLO holdings, up from 58%. And European CLO investments constituted 14% of our total CLO holdings, roughly unchanged from the prior quarter. On Slide 10, we show that our Agency RMBS holdings decreased slightly to $504 million from $512 million at December 31st. As Larry mentioned, we disposed of all of our remaining mortgage positions shortly after April 1st. Slide 11 details our interest rate hedging portfolio where you can see that our rate hedges were entirely in short TBA positions as of March 31st. And Slide 12 illustrates our net RMBS exposure where you can see that our net short TBA position fully offset our long agency pools. We also maintained modest credit hedge and foreign currency hedge portfolios at quarter end related to our CLO investments. Slide 13 illustrates that nearly all of our loans underlying our CLO portfolio are floating rate and as such, have much lower interest rate duration than agency mortgages. In connection with the conversion, we also changed our fiscal year to end on March 31st the day prior to the conversion with our first full fiscal year following conversion to end on March 31, 2026. Therefore, the three month period ended March 31, 2025, during which time we operated as a taxable C corporation, will constitute its own short fiscal year. Next month, we will be filing a transition period 10-K for that short three-month fiscal year. Then moving forward, as a closed-end fund, we will be making 1940 Act filings such as N-CSRs, N-CEN and N-PORT rather than 10-Qs and 10-Ks. So we still plan to continue issuing earnings releases on a quarterly basis. Finally, as a closed-end fund, we will be reporting a net asset value per share moving forward, which is substantially the same metric as the book value per share we've reported previously. With that, I'll pass it over to Portfolio Manager, Greg Borenstein to discuss how the CLO market has performed, how we've positioned our CLO portfolio and our market outlook.

Thanks, Chris. It's a pleasure to speak with everyone today. Calendar Q1 presented a number of headwinds, particularly for CLO equity. While payment default rates remained low and fundamentals strong in general, there were several challenging technicals. Continued loan coupon spread compression to start the quarter, coupled with loan price declines to end it weighed on CLO equity valuations. These phenomena were most pronounced in the US, while the impact on European positions was comparatively muted. In CLO mezz, while our US positions did experience mark-to-market declines as well, those declines were smaller than on equity, and mezz also outperformed most other corporate credit markets on a credit beta adjusted basis. Meanwhile, for our European mezzanine positions, strong carry and realized gains exceeded mark-to-market losses. We also had gains, albeit at modest ones from our credit hedges. In CLO equity early in the quarter, loan coupon spread compression continued to be an issue with the majority of the loan market trading above par to start the year. This caused CLO net interest margins to contract, which weighed on equity interest payments. On the other hand, some deals were able to benefit from resets and refinancing. And at EARN, we had gains from deals that liquidated, offsetting some of the mark-to-market declines elsewhere in the portfolio. Loan coupon spread compression concerns have since receded as only 10% of the loan market traded above par by the end of March and just 4% by the end of April. However, with the May rallies, that percentage has begun to creep up again. Loan prices closed calendar Q1, down $0.82 based on the Morningstar/LSTA US Leveraged Loan Index, declining in sympathy with the sell-off across credit markets. CLO debt tranches, particularly AAAs, saw their credit spreads widen in the quarter. This weakness was driven by several factors, including weakness in investment-grade and high-yield corporate bonds, CLO ETF capital outflows, heavy primary CLO supply, and elevated macro volatility. Wider credit spreads on CLO debt tranches resulted in CLO equity refinancing and reset options becoming less valuable, which also negatively pressured CLO equity prices. These effects were also more pronounced in the US than in Europe. And as a result, our European CLO equity investments outperformed their US counterparts in the quarter. Meanwhile, our Mezz portfolio, both in the US and Europe held in better. Higher quality BBs remain well supported by real money investors and hence had relatively limited price declines on the quarter. While our CLO portfolio had become more concentrated in CLO equity in prior months, we have more recently seen compelling value in mezzanine tranches once again. And we have been directing our excess interest cash flows and sale proceeds into some highly attractive BB investments accordingly. We believe these investments will help balance the portfolio and protect us from the potential of increased credit defaults, given continued uncertainty surrounding tariffs and their effect on the fundamental picture for credit moving forward. The outperformance of Europe versus the US and of mezz versus equity during the quarter demonstrated the benefits of diversification in our portfolio. We intend to remain active in both the US and Europe and in both equity and mezz based on relative value. I believe the market volatility overall has been a big positive for EARN. As Larry mentioned earlier, we came into April with cash to deploy. While we experienced some mark-to-market losses in calendar Q1, most of the price declines were driven merely by credit spread widening as opposed to by accelerating realized credit losses. We were able to be opportunistic with our deployment and take advantage of these wider spreads. Indeed, much of the credit widening has retraced so far in May. Looking ahead, we will continue to prioritize portfolio liquidity and agility as the current trading environment may demand great flexibility in response to an uncertain credit backdrop. Now back to Larry.

Thanks, Greg. I commend Mark Tecotzky and his team for doing an incredible job rotating out of our agency mortgage positions with minimal impact on net asset value in what was an extremely challenging market around the tariff announcements. We sold our last mortgage pool on April 7th. And as a final tally, our Agency mortgage strategy generated positive portfolio income for 2025 of about $2.55 million. In contrast, over the same timeframe, the Bloomberg US Agency MBS Index generated a significantly negative return versus treasuries. With the conversion now behind us, I am excited to have dry powder for our portfolio managers to deploy in such a compelling market. Since the April 1st conversion, we've bought an additional $51 million of CLO investments through yesterday. And we've also sold some positions at profits that we thought had become too fully valued. With the mortgage pools gone, our debt leverage now stands at less than half a turn. We started April with a net asset value of $6.08 per share. While additional credit spread widening in April did drive further CLO price declines, the effect on our portfolio was contained and we ended the month of April with an estimated net asset value in the range of $5.85 per share to $5.91 per share. I am pleased to announce that similar to what most other CLO-focused closed-end funds do, we have started posting on our website a brief tearsheet, where you can find updates of many of our portfolio metrics as of month end. We plan to continue posting these tearsheets on a monthly basis going forward. You can find our monthly tearsheet right on our home page, www.ellingtoncredit.com, by clicking on the link labeled monthly NAV and portfolio update. I'll give you a few moments now to open up the tearsheet. As you can see, there's a lot of information assembled on this page, but I'd like to highlight a few things in particular. Near the top in the common stock data section, you'll see our April 30th range of estimated NAV per share centered around $5.88 per share, as well as our monthly dividend and dividend rate. Then to the right, in the CLO portfolio underlying loan data section, you'll see a bunch of statistics on the corporate loans underlying our CLO investments. Moving down the page in the portfolio overview section, you'll see the breakdown of our portfolio as of April 30th, including the fact that coming into May, a full 18.8% of our total portfolio, or about $59 million, was in cash and cash equivalents. So you can see that we have plenty of dry powder to deploy in the aftermath of the April market weakness. Finally, to the right, you'll see the total return performance of our stock in April versus a few relevant indices, whether measured on a stock price-based total return basis or on an NAV-based total economic return basis. I think you'll find that our April performance compared very favorably with that of other CLO-focused closed-end funds. Moving on to May. I'll just mention briefly that so far this month, we've seen a good amount of credit spread tightening, which of course, has been a tailwind for our NAV. As of last night, our total CLO portfolio stood at $284 million, up from $250 million at the time of our conversion. Amid the ongoing elevated market volatility, we continue to add investments selectively in both CLO mezz and CLO equity, and we continue to actively trade the portfolio to take advantage of relative value opportunities between subsectors, all while drawing on the disciplined risk management that we're known for. Even as we've been putting capital to work, we have also been maintaining high levels of liquidity so we can still play offense should we see further market dislocations. This kind of dynamic market environment is where I believe our active management approach will shine. As we continue to ramp up our CLO portfolio, I believe we are in an excellent position to drive strong earnings and unlock value for shareholders moving forward. We will also look to add corporate debt to our liability structure later this year, which should be accretive to net investment income. Now let's open up the floor to Q&A. Operator, please proceed.

We'll take our first question from Eric Hagen with BTIG.

The timing of the divestment of the Agency portfolio couldn't have been better. You mentioned that $50 million of CLOs have been acquired since the conversion. How do the yields on those assets compare to the $250 million that was in the back book? Also, do you currently have any capital available to deploy, or are you fully invested at this time?

So as you can understand, the market has gone through been in a few different places since April 1st. I think that overall, the weighted average yield that we purchased, I would say, varied from slightly wider to some things were potentially hundreds of basis points back. I think what's important to note too is, it's not simply like we scaled up the portfolio pro rata. As we spoke about early on when we started buying CLOs, we were buying a lot of discounted mezzanine paper as we thought that was the best risk-adjusted return. We started shifting more heavily into equity, in particular in new issue as the market dislocated a bit, new issue investments stopped. And I think that more of the additions were potentially shifting back balancing into mezzanine. And so simply looking at the overall return in some of these cases, the profile of some of the bonds we were purchasing changed based on investment thesis. So just caveating that it should be broken out by different types of sectors. But overall, it ranged from moderately wider to hundreds of basis points.

And then I think did you also ask about...

Dry powder...

We still have a substantial amount of cash reserves. One interesting aspect of our risk management approach is that it allows us to effectively increase our dry powder. We maintain cash reserves, and as we implement more credit hedges, we essentially build up our dry powder. This means that we can expand the asset side of our portfolio as we take on more credit risks. Given that spreads have tightened significantly, we plan to add more credit hedges soon, which will further enhance our risk management and increase our available dry powder. Therefore, we have plenty of capacity to grow the portfolio beyond the previous figure of $284 million that I mentioned earlier.

I imagine you guys are following the headlines for the asset management industry making a push for 401(k) plans to have better access to the private equity industry. I'm just curious what your perspective's on this are? I mean, does it mean a more efficient market and tighter spreads and that's a good thing or is the CLO market so big and growing so fast at this point that a huge influx of demand wouldn't necessarily disrupt this really high and attractive return that you're getting in the asset classes right now?

I think it will be a while until you see that filter down to the CLO asset class. But in terms of having an impact on spreads, Mark or Greg, do you have any thoughts on that?

I'd say that the first order effect of this can be seen not in the closed-end fund space necessarily even though there's obviously a lot of retail demand. But you've seen in the ETF sector, looking at the growth of overall especially AAA ETFs, perhaps that's more an appropriate first step in terms of where that type of money would flow into here, maybe it filters down to this eventually. I think that their second order effects, we saw that CLO issuance was incredibly robust exiting 2024 into 2025 as that demand coming into AAAs through the AAA ETFs were tightening AAA levels to increase the attractiveness of securitization. So it's a bit of a double edge, it can couple of ways, I guess, where perhaps it compresses yields at some point if there's demand, but also perhaps that demand is coming into the liability side, which could just be creating an attractive arb for the equity further down. So there are several factors at play where we sort of have to wait to see how it shakes out in terms of what the true effect would be.

We'll take our next question from Crispin Love with Piper Sandler.

Following up on the dry powder question, where I believe you said you're at $284 million today in CLOs. First, what does fully deployed look like? And when would you expect to be fully deployed? And were you more aggressive in putting capital to work in early to mid-April, given the price moves relative to your initial expectations for redeployment?

Greg, do you want to answer the second part and then I'll come back to the first part...

I'm quite pleased with the situation. We might be considering additional factors. Overall, we aimed to invest based on the conversion opportunities we identified. We noticed that prices were becoming more favorable towards the end of March. Many in the market would agree that similar bonds were trading much better by the end of April, and we experienced a significant rally throughout that month. By the end of April compared to early May, it's difficult to pinpoint exactly, but in some instances, conditions were actually improved by late April than they were at the end of March. We decided to increase our investments as it seemed like a good opportunity. Initially, we expected the ramp-up to take longer. The pace and available resources depend, as Larry mentioned earlier, on how much leverage we choose to utilize. It's crucial that this vehicle remains liquid during any market shocks or downturns. Therefore, a key objective of our credit hedges is to ensure we maintain liquidity in these circumstances. Overall, if we identify numerous opportunities and the calculations indicate that financing a portion of the market we wish to invest in, including the costs for downside protection, makes sense, we could see growth and potentially increase our liquid resources. Currently, we've experienced a sell-off followed by a recovery; while we're not back to our tightest positions, we've seen a significant rebound. Consequently, we're not being as aggressive as we could be with our capital right now due to our market outlook.

I'll just add that if you take the midpoint of $5.88 per share as our net asset value coming into May, multiplied by the latest share count we disclosed, that's about $220 million of equity. As Greg mentioned, it really depends significantly on the mix between mezzanine and equity in the portfolio. We've been actively trading and exploring different subsectors from a rotational standpoint. I believe we could easily have half a turn of leverage, which would put us over the $300 million mark regarding CLOs in the portfolio. Much of this is dependent on how we risk manage the portfolio, which is where most of the limits come into play. I also want to highlight that we are a full derivative user. This requires us to comply with various tests, which involves a bit more work on our part, but it's manageable. The advantage is that we can use a repo and account it as a derivative rather than as a senior security, which would impose stricter restrictions on our leverage as a closed-end fund. Ultimately, it will rely more on our risk management and portfolio composition than on the typical leverage restrictions you might expect. We could easily exceed the $300 million market with our current equity base. Additionally, we are planning to issue unsecured debt later this year, and this will also help mitigate short-term risks associated with repo, as longer-term unsecured debt provides more stability. This approach will enable us to have more assets for each dollar of equity from a risk management perspective.

And then last question from me. Can you share your latest thoughts on the ADE trajectory? Last quarter, you talked about likely not covering the dividend in the calendar second quarter, just given the MBS sales and elevated cash prior to full redeployment and then coverage resuming in the calendar third quarter. Do you have any updates there or any finer details?

I think we're still on plan there. So exactly, we might be a little short this quarter, but I think on track for the third quarter.

Thank you. And that was our final question today. We thank you all for participating in Ellington Credit Company's first quarter 2025 financial results conference call. You may disconnect at this time and have a wonderful day.