Ellington Residential Mortgage REIT (NYSE:EARN) Q1 2023 Earnings Call Transcript
Ellington Residential Mortgage REIT (NYSE:EARN) Q1 2023 Earnings Call Transcript May 12, 2023
Operator: Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT 2023 First 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: 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 all 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, our Chief Executive Officer; Mark Tecotzky, our Co-Chief Investment Officer; and Chris Moreno, our Chief Financial Officer. As described in our earnings press release, our first quarter earnings conference call presentation is available on our website, artonreid.com. Our comments this morning will track to the presentation. Please note that any references to figures in the presentation are qualified in their entirety by notes at the back of the presentation.
With that, I will now turn the call over to Larry.
Larry Penn: Thanks, Alaael-Deen, and good morning, everyone. We appreciate your time and interest in Ellington Residential. Last year was just about the worst year on record for Agency RMBS but the year actually ended on a constructive note, and that positive momentum continued into January. In anticipation of a slow pace of interest rate hikes by the Federal Reserve, interest rates and interest rate volatility continued to decline precipitously in January, and yield spreads tightened further. Capital flowed into Agency MBS, while new mortgage supply remained low. And for the month, Agency MBS significantly outperformed treasuries. Ellington Residential itself has had a positive economic return of over 6% in January. Markets reversed course in mid-February, however, triggered by renewed concerns over inflation and what the Fed's response would be.
volatility and spreads increased, while interest rates, especially short-term interest rates surged. By early March, the 2-year treasury yield rose 97 basis points in less than 1 month and surpassed 5% for the first time since 2007. Then turmoil in the regional banking system roiled markets, causing volatility to spike and pressuring spreads further. Treasury yields plummeted, and many fixed income sectors sharply underperformed in March, including agency MBS. Overall, the negative MBS performance in February and March exceeded the positive returns in January. And for the full first quarter, agency MBS ended up with a negative 50 basis point return versus treasuries. Despite these challenges, however, Ellington Residential generated positive net income of $0.17 per share and adjusted distributable earnings of $0.21 per share for the quarter.
The first key to our outperformance was our portfolio construction. Over the past several quarters, we have been opportunistically but steadily rotating out of our lowest coupon MBS. We entered the year with only about 15% of our long Agency portfolio in coupons under 3%. We also carried a meaningful TBA net short position in those coupons. It was sub-3% coupon MBS that were hardest hit in March because they comprise a significant portion of the portfolios of those troubled regional banks and the ever-increasing prospects of asset sales hitting the market weighed heavily on those low coupons. So we were awarded for both paring down our long exposure and maintaining a net short position in this low coupon cohort. We also limited our investments in the highest coupon MBS, namely coupons above 5.5%.
This had 2 benefits. First, it shielded us from some of the technical pressures on new production, especially with the Fed no longer a buyer. Second, it had the benefit of reducing our negative convexity and thus reducing our delta hedging costs, especially during that extreme bond market volatility in the last half of the quarter. In mid-March, implied short-term volatility on treasuries was the highest seen since the global financial crisis. So the second benefit was actually quite significant during the quarter. As you might infer, we found the best relative value during the quarter and the intermediate coupons of the stack. And in specified pools, we continue to focus on lower pay-up stories where we saw better risk-reward trade-offs. During the first quarter, we made positive carry on our long specified pools versus short TBA and especially versus SOFR hedges with the floating rate we receive much higher than the fixed rate that we pay.
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And as Mark will discuss, with all the volatility during the quarter, we took advantage of tactical trading opportunities to add excess returns, and our agency portfolio turnover rate was 23%. Finally, our larger non-Agency and IO portfolios also contributed nicely to our first quarter results, driven by strong net interest income in the portfolio. We expect to continue to add to these portfolios in the coming months. As we discussed on last quarter's earnings call, our pivot away from low coupon pools also enabled us to enter the first quarter with reduced leverage and excess liquidity. Given the prospect of continued bank portfolio asset sales and continued volatility, we have been judicious about adding back leverage, and we closed the first quarter with only slightly larger agency and non-agency MBS portfolios.
Our leverage ratios ticked up just slightly quarter-over-quarter, but we are still far from the high end of where we're comfortable adding leverage, and we're also far from the high end of where you could see our net mortgage assets equity ratio going. Spreads are wide, but there's the potential for them to go wider, and we have room to lean into wider spreads. Finally, we continue to methodically turn over our portfolio to improve our net interest margin and adjusted distributable earnings. And as you can tell, we still have plenty of dry powder to take advantage of investment opportunities as the year unfolds. I'll now pass it over to Chris to review our financial results for the quarter in more detail. Chris?
Chris Smernoff: Thank you, Larry, and good morning, everyone. Please turn to Slide 5 for a summary of Ellington Residential's first quarter financial results. For the quarter ended March 31, we are reporting net income of $0.17 per share and adjusted distributable earnings of $0.21 per share. These results compare to net income of $0.88 per share and ADE of $0.25 per share in the fourth quarter. ADE excludes the catch-up premium amortization adjustment, which was negative $299,000 in the first quarter as compared to positive $658,000 in the prior quarter. We had a net gain on our Agency RMBS portfolio for the quarter as net realized and unrealized gains on our specified pools exceeded net losses on our interest rate hedges and slightly negative net interest income.
The quarter-over-quarter decline in our net interest income was a result of sharply higher financing costs, which were driven by increasing short-term interest rates as certain older and low-rate repos matured and were replaced with repos reflective of the current higher rate environment. Our asset yields also increased during the quarter, but by a lesser extent. As a result, our net interest margin decreased to 1.16% from 1.37%. Additionally, we continue to benefit from positive carry on our interest rate swap hedges, where we receive a higher floating rate and pay a lower fixed rate during the quarter. Our lower NIM drove the sequential decrease in ADE. Meanwhile, pay-ups on our specified pools decreased to 1.09% as of March 31 from 1.26% at year-end, first, because the average pay-ups on our existing specified pools decreased quarter-over-quarter and second, because new purchases during the quarter consisted of pools with lower pay-ups.
Please turn now to our balance sheet on Slide 6. Book value was $8.31 per share as of March 31 as compared to $8.40 per share at year-end. Including $0.24 per share of dividends in the quarter, our economic return was a positive 1.8%. We ended the quarter with cash and cash equivalents of $36.7 million, which increased quarter-over-quarter. Next, please turn to Slide 7, which shows a summary of our portfolio holdings. Our MBS holdings increased by 3% to $891 million as of March 31 as compared to year-end as net purchases and net gains exceeded principal paydowns. As Larry mentioned, our Agency RMBS portfolio turnover was 23% for the quarter, which was an increase over the prior quarter. Over the same period, our holdings of interest-only securities and non-Agency RMBS increased by $4.6 million in total.
Our debt-to-equity ratio adjusted for unsettled purchases and sales decreased slightly to 7.5x as of March 31 from 7.6x at year-end. The decrease was primarily due to a larger shareholders' equity quarter-over-quarter, partially offset by an increase in borrowings on our larger Agency RMBS portfolio. On the other hand, our net short TBA position declined during the quarter, which, combined with our larger agency -- our larger MBS portfolio more than offset the impact of the increase in shareholders' equity. As a result, our net mortgage assets to equity ratio increased to 6.9x from 6.6x at year-end. Finally, on Slide 8, you can see details of our interest rate hedging portfolio. During the quarter, we continued to hedge interest rate risk through the use of interest rate swaps and short positions in TBAs, U.S. Treasury securities and futures.
We again ended the quarter with a net short TBA position. I will now turn the presentation over to Mark.
Mark Tecotzky: Thanks, Chris. I'm pleased with earned results for the quarter. We had a total return of 1.8%. That was in the face of some pretty extraordinary interest rate volatility and a banking crisis resulting in a sizable supply shock for Agency MBS. I'm very excited about the opportunity set going forward. Today, Agency MBS yield spreads are historically very wide relative to hedging instruments, prepayment risk is limited, and we see little or no competition for assets from what have historically been the 2 largest pools of low-cost capital for the Agency MBS, the Fed and U.S. banks. Meanwhile, organic supply from new origination is down hundreds of billions of dollars from years past. The FDIC has seized a significant amount of Agency MBS recently from failed regional banks, and they've been in the process of divesting those assets.
So we've seen a significant supply of Agency MBS hit the market in recent weeks. Over 7 billion current piece [ph] have already been sold at that pace and assuming no more asset seizures occur, we should see the sales finished by October. So far, the lists have been trading at or above primary dealer talk. So while MBS spreads are wide, they have not widened further since the sales have started. Our conclusion is that widespread levels have attracted new capital to the sector, and so there may be significant support at these wider levels. Don't get me wrong, agency spreads should stay high. There's not going to be any bank buying in the short term only bank selling, and the Fed isn't fine. They're just letting their portfolio run off. The only significant positive technical is smaller new issue supply.
So we think these wider spread levels may be with us for a while. The Fed's balance sheet has been contracting and banks have bought almost no security since the run-up in rates last year. We expect looming future regulation and balance sheet pressures will mean that banks with under $250 billion in assets won't buy much this year either. Putting it all together, we think it's a great time to be an agency mortgage investor. None of the other regional banks recently in the news have sizable Agency MBS holdings. So it may be that the worst is behind us. And the recent capital flows into diversified fixed income bond funds and ETFs and into mortgage focused funds have been significant stabilizing force for spreads. Meanwhile, repo financing continues to be plentiful and stable.
Yield spreads are so wide that you don't need spread tightening to drive returns; just the capture of net interest margin alone can do the job. With the banks and the Fed shrinking in CMBS, market requires much higher expected returns on capital. And in today's prepayment environment, NIM capture is much more certain. This is a very different dynamic from 2022 because now the Fed has signaled that they are nearing the end of their hiking cycle, and the yield curve has started to reverse a lot of the inversion we had seen. That guidance has led to a much more positive investor view of fixed income in recent weeks. Going back to our portfolio activity for the quarter, we leaned into the wider yield spreads by growing our portfolio slightly during the quarter.
We think the widespreads today adequately compensate us for the supply shock from the FDIC sales. We added 30-year MBS, shrunk 15 year and went up in coupon a little bit. We have generally favored intermediate coupons, specifically 3 through 4 in half, which we are calling the Goldilocks coupons. They're high enough in coupons that banks and the FDIC don't own much because they weren't being produced in significant size in 2020 and 2021, but they are low enough in coupon that they don't require a lot of delta hedging and there is limited current production. In addition, Ginnie Mae’s have gotten cheaper relative to UMBS. So we have been adding exposure there as well. We believe future banking regulations will favor Ginnie's over conventionals because of their lower capital charge.
All this volatility has created some good relative value opportunities to add incremental returns to the portfolio as well. For example, on January 5, we bought a bunch of Fannie 4.5 hedged with Fannie 4s in a duration-weighted basis. The next -- the very next day, the market rallied around 20 basis points and the 4.5% basically kept pace with the forset huge move. So we were able to reverse our trade 1 day at a significant profit. If you believe the forward curve, which is calling for lower rates a year from now based on the expectation of a recession that may be a very good backdrop for AD&C MBS. Agency MBS tend to do quite well in recessions when fears of rating downgrades on corporates attract capital away from corporate bonds and towards Agency MBS, which are not exposed to credit risk.
Despite a Fed that seems likely to be on the sidelines in the coming months, we remain diligent about our interest rate hedges, and we remain focused on harvesting the many opportunities this market has created to help drive incremental returns. Now, back to Larry.
Larry Penn: Thanks, Mark. I'm pleased with Ellington Residential's performance to start the year. In a quarter of extreme interest rate volatility and widening agency spreads, earner is able to generate an annualized economic return of 7.3%, while keeping leverage low and liquidity high. So far in the second quarter, volatility has eased from its mid-March highs, and the FDIC sales have been orderly and their impact on the market less than feared. Overall, the mortgage basis and option-adjusted spreads widened in April, but May has been quite stable. Looking ahead, continued volatility in forced selling, especially from banks, could generate some exciting investment opportunities for us as they have in the past. Agency spreads are currently very wide and pay up on specified pools in many sectors low, and much of our portfolio requires little delta hedging.
And despite the volatility, funding markets remain healthy. In addition, relative value opportunities in the non-agency sector are plentiful. It's a great time to have dry powder, and we look forward to deploying it as we see opportunities. We will continue to pursue ERM's dual mandate to preserve book value when markets are volatile, as we did this past quarter when we were solidly profitable, no less and to capture the upside when markets recover. With that, we'll now open the call to questions. Operator?
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