Earnings Call Transcript - EARN Q2 2025

Operator, Operator

Good morning, everyone. Thank you for joining us. Welcome to the Ellington Credit Company conference call to discuss the fiscal quarter results ending June 30, 2025. This call is being recorded. I will now hand over the call to Alaael-Deen Shilleh, Associate General Counsel. Please proceed.

Alaael-Deen Shilleh, Associate General Counsel & Secretary

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 detailed in our 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; and Chris Smernoff, Chief Financial Officer. Our earnings conference 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 it over to Larry.

Laurence Eric Penn, CEO

Thanks, Alaael-Deen, and good morning, everyone. We appreciate your time and interest in Ellington Credit Company. Please turn to Slide 3. Ellington Credit had an excellent quarter, which technically was the first fiscal quarter of our new fiscal year. In this, our first full quarter as a registered closed-end fund, we generated an annualized economic return of nearly 20% net and grew NAV per share. Our strong results were driven by excellent performance across both CLO equity and mezzanine investments as well as by the timely redeployment of capital following the April sale of our legacy mortgage-related holdings. Thanks to excellent execution by Mark Tecotzky and his team. We successfully completed the disposition of our remaining mortgage-related investments with minimal NAV impact, and then proceeded to grow our CLO portfolio by 27% quarter-over-quarter to $317 million, as shown on Slide 3. Please turn now to Slide 4. Market conditions were quite wide-ranging in calendar Q2. Following surprise tariff announcements on April 2, heightened macroeconomic uncertainty led to sharply lower prices across the board on risk assets. However, after the April 9 tariff pause, risk sentiment rebounded quickly, sparking a broad market rally. By quarter end, both volatility and credit spreads had fully retraced their earlier upticks and many equity indices reached their all-time highs. As you can see on this slide, credit spreads on both U.S. corporate high-yield and investment-grade bonds tightened overall in the quarter, with May and June's recovery more than offsetting April's weakness. Turning to the specific sector that we focus on, namely CLOs. You can see on the top of the page that CLO mezzanine tranches, especially BBB-rated tranches also performed well in the quarter, although not quite as well as high-yield corporates. CLO equity also generally performed quite well. As also shown on this slide, CLO issuance remained high by historical standards, but was lower than in recent quarters, reflecting the impact of all that intra-quarter volatility. At EARN, having sold all our remaining agency pools in early April, our timing was fortunate given the contemporaneous risk-off price action. And so we moved quickly to begin redeploying that freed-up capital into CLO investments. While our quickness allowed us to add CLOs at their 2025 lows in April, we also continued to deploy capital into compelling CLO investments throughout the remainder of the quarter. As I noted previously, CLOs didn't actually end up recovering quite as much as high-yield corporate bonds did, and that was a good thing for us, given that we still had more capital to put to work. The key driver of our excellent performance this quarter was strong net investment income from both our CLO equity and CLO mezzanine positions, complemented by opportunistic trading, the redemption at par of two mezzanine positions that we had bought at discounts to par and the successful readout of a CLO in which we hold equity, all of which contributed to the growth in our NAV per share. We still have ample dry powder today and putting that to work should boost our net investment income in the coming months. At our current rate of deployment, we project that starting with September, our monthly net investment income will cover our $0.08 monthly distribution. At that point, we'll consider ourselves to be close to fully invested. With our closed-end fund conversion now behind us, we are now benefiting from all the enhancements that the closed-end fund structure brings us, including the tax efficiency of pass-through RIC taxation and the ability to focus fully on CLO investments. I am confident that our new structure and strategy will support earnings growth and help us capitalize on the compelling opportunities we continue to see in the CLO market. I'll turn it over to Chris now to walk through some more of the financial details. Chris?

Christopher Max Smernoff, CFO

Thanks, Larry, and good morning, everyone. Please refer to Slide 3. For the second quarter, we reported a GAAP net income of $0.27 per share and an adjusted net investment income of $0.18 per share. The weighted-average GAAP yield for the quarter on our CLO portfolio was 15.6%. Now, moving to Slide 6, you can see a breakdown of portfolio net income by CLO subsector: $0.12 from U.S. CLO debt, $0.02 from European CLO debt, $0.23 from U.S. CLO equity, and a $0.01 loss on European CLO equity. Each subsector contributed significantly to net investment income, as shown in the middle of Slide 6. Our results also benefited from substantial net realized and unrealized gains on U.S. debt and equity, reflecting active trading during the quarter and deal calls on two mezzanine positions held at discounts to par, along with a favorable reset of a CLO equity position. Slightly offsetting these gains were net unrealized losses on our European CLO equity and a modest impact from credit hedges intended to protect against downside risk. In the U.S., leveraged loan prices increased quarter-over-quarter despite a sharp pullback in early April. Within CLO debt, higher quality, deleveraging profiles showed the best performance. However, heavy issuance late in the quarter prevented credit spreads from tightening further, and we continue to see heightened loan credit dispersion, particularly among lower-quality borrowers. U.S. CLO equity achieved strong results driven by robust investor demand and a decrease in market volatility, with new or recently reset CLOs that feature long reinvestment periods significantly outperforming shorter tenor profiles that are more sensitive to loan prices. In Europe, leveraged loan prices saw modest gains but did not keep pace with the rebound in the U.S. Wider credit dispersion negatively affected returns, especially in junior tranches; nonetheless, a stronger investor appetite for non-U.S. credit provided some mitigation. European CLO equity underperformed relative to U.S. equity during the quarter due to more subdued loan market gains and increased dispersion. However, some investor rotation into European structures helped alleviate the impact. Slide 7 outlines our CLO portfolio, showcasing sequential growth. Overall, the CLO portfolio increased by 27% to $317 million. During the quarter, we made new purchases totaling $91 million, with 88% allocated to CLO debt and 12% to CLO equity, while selling $16 million of CLOs consistent with our active trading approach. As of June 30, CLO equity represented 53% of our overall CLO holdings, down from 58%, while European CLO investments accounted for 14% of our total holdings, remaining relatively unchanged from the previous quarter. As Larry pointed out, we divested all of our remaining mortgage positions shortly after our RIC conversion, which took effect on April 1. The net impact of these disposals on our NAV was just about $0.01 per share. Slide 8 presents details on the corporate loans that back our CLO investments. The collateral heavily leans towards first lien floating rate leveraged loans, constituting 95% of the underlying assets. Industry exposure is well-diversified, led by technology, financial services, and healthcare, with no single sector exceeding 11%. Maturities are spread out over several years, with the largest concentrations in 2028 and 2031, and a few near-term maturities, leading to a weighted-average loan maturity of 4.2 years. Facility sizes are skewed toward larger borrowers, with 42% in facilities exceeding $1.5 billion and a weighted-average size of $1.6 billion, which supports liquidity. Slide 9 gives more detail on our underlying loans. The portfolio encompasses 2,205 unique issuers, 95% of which are senior secured loans, holding an average rating of B+, B with a 3.34% floating rate spread. Currency exposure is 86% in U.S. dollars and 14% in non-U.S. currencies, while our CLO equity positions have a weighted-average junior over-collateralization cushion of 4.58%. Slide 10 provides a summary of our credit hedges as of June 30. We carefully and strategically hedge portions of our CLO portfolio's credit risk using a variety of derivative instruments. During the quarter, as credit spreads tightened, we took the opportunity to expand our corporate credit hedges significantly. By the quarter's end, we also maintained a foreign currency hedge portfolio to manage exposure associated with our European CLO equity and debt investments. Turning to Slide 11, at June 30, our NAV was $6.12 per share, and cash and cash equivalents totaled $36.6 million. Our NAV-based total return for the quarter was 19.7% annualized. With that, I'll hand it over to Gregory Borenstein to discuss the performance of the CLO market, our positioning within the CLO portfolio, and our market outlook.

Gregory Borenstein, Portfolio Manager

Thanks, Chris. It's a pleasure to speak with everyone today. As Larry mentioned, calendar Q2 was ultimately very profitable for EARN, but the path to get there was highly nonlinear. April was incredibly volatile as the announcement of tariffs sent the market into a tailspin and corporate credit spreads sharply wider to start the month. After the tariffs were paused, which allowed markets to stabilize, credit spreads spent much of May and June grinding back and ended tighter on the quarter overall. In our U.S. CLO portfolio, both equity and mezz tranches saw significant gains, while in Europe, returns were more muted given the higher starting point. That said, European CLOs have delivered solid performance year-to-date for EARN given the outperformance of European CLO notes in Q1. While the drawdown and subsequent retracement in CLO mezz were well correlated to broader market moves in credit, CLO equity saw increased dispersion in a few dimensions. In April, we saw cleaner, longer deals remain well supported, whereas shorter deals that are more sensitive to their underlying loan valuations saw a sharper drawdown as loan prices declined. Additionally, equity tranches where the market had been pricing in resets or refinancings underperformed as those options disappeared as CLO debt spreads widened. As we sit here today, many of those options have recovered, but they remain less in the money than they were at the beginning of the year. This is largely because AAA spreads have struggled to return to January, February levels. On the positive side for CLO equity, post-April loan price decreases reduced prior concerns surrounding loan coupon spread compression and any resulting net interest margin erosion. What's more, loan payment defaults remained low throughout the quarter, ending June 30 at 1.11% on a trailing 12-month basis on the Morningstar/LSTA U.S. Leveraged Loan Index. Overall, we have been focused lately on increasing our portfolio's relative concentration to CLO mezz. We believe that increasing exposure to these up in credit positions, along with adding credit hedges, helps to protect the portfolio and serves as nice complements to our CLO equity positions. Additionally, we have also shifted our focus more to the secondary market as compared to the primary market as the dislocation experienced in parts of Q2 created many more secondary market opportunities. In fact, EARN did not participate in any new issue equity transactions in Q2 as we have found better relative value in secondary markets in recent months. As mentioned before, CLO liabilities, specifically AAAs have struggled to return to their tights. Meanwhile, as of July 31, a considerable 46% of the loan market traded above par. Significant repricings in the loan market are reigniting concerns about spread compression, and with AAA spreads still struggling to retrace to their 2025 tights, new issue CLO equity arbitrage has come under pressure. Our emphasis on CLO mezz in the current environment also reflects our concern that the persistence of higher base tariff rates, coupled with ongoing uncertainty around future tariff policy will continue to drive dispersion in credit for the foreseeable future. As our results show, EARN took advantage of Q2's market uncertainty, reaping the benefits of active trading during bouts of market volatility. On the quarter, we had 79 unique CLO trades, not counting any deal liquidations or credit hedge trades. I believe the portfolio is well balanced with core positions built for stability and others offering meaningful upside and attractive optionality. We will continue to shift allocations as the market environment changes, be it between mezz and equity, primary and secondary, or U.S. and Europe. Now back to Larry.

Laurence Eric Penn, CEO

Thanks, Greg. Calendar Q2 was a great quarter for Ellington Credit Company and a great start to our new form as a closed-end fund. We not only put up strong earnings, but we also ended the quarter with a diversified, high-quality CLO portfolio and ample dry powder to boot. Calendar Q3 is off to a strong start as we delivered another month of excellent results in July, expanded the portfolio and grew NAV further. As of now, our CLO portfolio stands at around $360 million, up from $320 million coming into Q3. Looking ahead, we see multiple ways to continue to drive performance and expand net investment income. Deploying our remaining dry powder is one way. And as I mentioned earlier, we project that our net investment income will fully cover our distribution rate starting in September. Another way is by issuing long-term unsecured debt, which we hope to do later this year. The additional leverage supplied by long-term unsecured debt should be accretive to both GAAP earnings and net investment income. But even with our current capital base and debt structure, we expect to increase our CLO portfolio by another $40 million to $400 million or so. I firmly believe that our rigorous approach to CLO investing, our active trading style, and our strategic use of credit hedges give Ellington Credit a unique advantage. With credit markets having recovered so much since early April, we've taken advantage by adding credit hedges at better entry points while still uncovering compelling opportunities in CLO equity and mezzanine debt across the U.S. and Europe. This relative value approach gives us the flexibility to target the best risk-adjusted returns as markets evolve. To recap, we've built what we view as a high-quality, well-diversified CLO portfolio, while keeping liquidity high and lining up multiple levers for earnings growth. Calendar Q2 was a powerful start for EARN, and we are confident in the opportunities that lie ahead. Now let's open the floor to Q&A. Operator, please go ahead.

Operator, Operator

We'll start with Doug Harter of UBS.

Douglas Michael Harter, Analyst

You just mentioned the situation regarding why AAA spreads haven't completely retraced while the underlying loan spreads have.

Gregory Borenstein, Portfolio Manager

Sure, it's Greg. I'll take that one. To clarify, AAAs are not experiencing the same demand as earlier this year. As we've mentioned before, we are focusing on the growth of the ETF market and a diverse foreign buyer base. This may be influenced by the expectation of a rate cut and some rotation into floating rates. AAAs had previously been the tightest among structured products and credit. Now, they are priced about 10 to 15 basis points wider. Overall, there's just a bit less demand for various reasons. Additionally, while loans have rebounded back to par, there aren't as many above par as there were earlier in the year when about 70% were above par on the loan side. While this change is noticeable, it's still within a range that allows for some margin for error regarding spreads catching up.

Douglas Michael Harter, Analyst

Great. Appreciate that. And assuming that dynamic doesn't change, would you expect your allocation to be kind of similar to what it was in the June quarter, more towards debt and equity?

Gregory Borenstein, Portfolio Manager

I think that if the market continues to stay challenged to this point, right, there's a number of factors that can obviously come into this if secondary markets become tighter and less attractive, removing that opportunity may also see some rebalancing. But overall, I think that we've tended to not like creating a new issue. And if the assets and liability math calculation doesn't change, it's hard to see why we would allocate more to it. So I would tend to agree with that.

Operator, Operator

We go next now to Jason Weaver of JonesTrading.

Jason Price Weaver, Analyst

I think in the beginning of your prepared remarks, you were talking about issuance trends and how were muted in the first quarter '26 just due to the volatility. So some of that has come down, some uncertainty has been reduced and we may see some monetary relief on the horizon. Would you expect that trend to reverse into calendar year-end?

Gregory Borenstein, Portfolio Manager

In reference to your mention of CLO issuance?

Jason Price Weaver, Analyst

CLO issuance in general.

Gregory Borenstein, Portfolio Manager

Sure. I thought that new issue activity at the end of last year and the beginning of this year looked more appealing, leading to more transactions. A key factor is whether loans versus debt spreads will become attractive enough to boost new issuance. It's difficult to predict. The market has seen more resets and refinancings, but a change could occur if monetary easing leads to better spreads from the assets in loans, potentially reigniting the new issue market. However, currently, new issue desks and many investors are focused on refinancings, resets, and liquidations, making it challenging to resume new issuance. If AAA assets come in and other assets move out, the shifts in these components are hard to forecast due to the uncertainties we've encountered recently.

Jason Price Weaver, Analyst

Got it. And then to just clarify a little bit of what Greg had said on the relative value between mezz and equity here. Any sort of perception of an increased risk to equity tranches? I mean you did mention tariffs in the prepared remarks.

Laurence Eric Penn, CEO

Right. I think if you take a look, tariffs are going to create winners and losers. There's uncertainty around different sectors around different companies. And so I think that we see equity as having more risk and exposure to tariffs being that they're a first loss tranche. So if there's a handful of names which are adversely affected, a subordinated mezz position will remain above the fray from a small amount of losses. If losses become so great that it starts to get through that attachment point and your mezz starts to perhaps look like equity there, which you've seen at certain rare occurrences in past periods such as COVID or the financial crisis. But if it sort of remains a tail issue, which if you look at credit markets, it's sort of been sort of just a tail of companies that have had problems, that continues to be a lower correlation event. And overall, it's something that would generally force first-loss positions such as CLO equity to underperform versus positions further up in the capital structure that are more spread sensitive and maybe less credit or fundamentally sensitive?

Jason Price Weaver, Analyst

Got it. That makes sense. And then just the last one, and I'll hop off. Do you have an updated quarter-to-date NAV estimate?

Christopher Max Smernoff, CFO

Just want me posted.

Laurence Eric Penn, CEO

Yes. We posted July 31 last night, a range around $6 to plus or minus $0.03.

Gregory Borenstein, Portfolio Manager

Yes, $6.16. That's correct and it is through the end of the quarter.

Operator, Operator

Thank you. And gentlemen, that was our final question for today. So we'd like to thank you all for participating in the Ellington Credit Company Fiscal Quarter ended June 30, 2025 Results Conference Call. You may disconnect your lines at this time, and have a wonderful day. Goodbye.