Q3 2023 Ellington Residential Mortgage REIT Earnings Call
Participants
Alaael-Deen Shilleh; Associate General Counsel and Secretary; Ellington Residential Mortgage REIT
Larry Penn; CEO & President, Trustee; Ellington Residential Mortgage REIT
Chris Smernoff; CFO; Ellington Residential Mortgage REIT
Mark Tecotzky; Co-Chief Investment Officer; Ellington Residential Mortgage REIT
Crispin Love; Analyst; Piper Sandler
Presentation
Operator
Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT 2023 third quarter financial results conference call. Today's call is being recorded. (Operator Instructions) It's 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 the information that we have filed with the SEC, including the earnings release, 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 provide or revise any forward-looking statement, 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 third quarter earnings conference call presentation is available on our website, earnreit.com. Our comments, this morning, will track the presentation. Please note that any references to figures in this presentation are qualified in their entirety by the note at the back of the presentation.
With that, please turn to slide 3 of the presentation and 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. The third quarter actually began on a constructive note. In July, inflation fell to its lowest year-over-year pace in two years, GDP growth beat expectations, and US equities and most credit fixed income sectors posted gains for the month. For Agency RMBS, FDIC selling of specified pools continue to be well digested by the market. And the US Agency RMBS index generated a positive excess return for the month over treasuries.
EARN had a positive economic return in July as well. The quarter got considerably more challenging from there, however. Realized volatility remained high and long-term interest rates continue their upward march, which puts significant pressure on Agency yield spreads. In particular, the Federal Reserve's hawkish messaging at its September meeting triggered a sell-off in most fixed income sectors, Agency RMBS included. Well, a possible government shutdown added to the uncertainty.
Yield on the 10-year treasury rose 82 basis points between mid-July and September 30. And the MOVE index, which tracks expected short-term interest-rate volatility remained elevated. Against this backdrop, Agency RMBS very significantly underperformed the comparable US treasuries and interest rate swaps during the quarter, with lower coupon RMBS exhibiting the most pronounced underperformance.
On slide 3 of the presentation, you can see that the dollar prices on Fannie 2.5 through 3.5 declined by more than 5 points sequentially. EARN generated an overall net loss of $0.75 per share for the quarter, with net losses on our specified pools exceeding net gains in our interest rate hedges and delta hedging costs, which are tied to interest-rate volatility remaining high.
On the positive side, our adjusted distributable earnings increased quarter over quarter, driven by further portfolio turnover, capturing higher market yields, while cost of funds remained relatively stable. In addition, a significant portion of the losses on our Agency RMBS for the quarter were unrealized and resulted from yield spread widening that could be largely recoverable if market volatility subsides. We sold some pools incrementally and we were able to avoid to avoid the forced selling that we saw from others in September and October.
We continued to hold a strong liquidity position at quarter-end with cash and unencumbered assets representing 38% of our total equity, with our leverage ratios roughly unchanged quarter over quarter. We continue to maintain additional borrowing capacity. Looking to the balance of the year, it's great to have dry powder available in a market rich with opportunities. Despite the rally of the past couple of weeks, Agency yield spreads remain very wide and the mortgage basis looks very attractive right now with the impact of elevated volatility and higher for longer interest rate environment seemingly fully priced in.
Furthermore, on a technical basis, late fall and winter seasonal effects should bring a drop in Agency RMBS supply. And the fourth quarter is typically a strong quarter for bank deposit growth and resulting security purchases. The main thing, keeping money managers and banks from returning to the sector in a meaningful way has been elevated volatility.
If volatility finally subsides somewhat, incremental institutional demand for Agency RMBS could be a significant driver of total returns for this sector in the coming months. I'm particularly excited to report that, towards the end of the third quarter, we started to allocate a portion of EARN's capital to corporate CLOs, specifically CLO mezzanine debt and CLO equity. While this has been a small allocation so far, I expect the allocation to grow significantly. And I'm very optimistic about what this could mean for EARN going forward.
Yield spreads on certain CLO mezzanine and equity tranches available in the secondary market are near levels we saw last in the summer of 2020, and the credit markets were still very much recovering from the COVID lows. Furthermore, no two CLOs are alike, which given Ellington's extensive CLO expertise, should create lots of trading opportunities and relative value opportunities for EARN to capture.
Ellington's strong and long-standing track record investing in CLOs in the secondary market should position EARN well to capitalize on both near term and the long-term opportunities we see in the sector. We are off to a good start as in the past six weeks EARN has acquired several CLO mezzanine debt and CLO equity tranches where we project returns on equity well in excess of 20%.
I believe that CLO mezzanine debt and equity pair very well with Agency RMBS, as a complementary strategy that will diversify and help drive EARN's earnings growth going forward. Mark will elaborate that later in the presentation.
I'll now pass it over to Chris to review our financial results for the third 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 third quarter financial results. For the quarter ended September 30, we reported a net loss of $0.75 per share and adjusted distributable earnings of $0.21 per share. These results compared to net income of $0.09 per share and ADE of $0.17 per share in the second quarter. ADE excludes the catch-up amortization adjustment, which was positive $46,000 in the third quarter as compared to a negative $376,000 in the prior quarter.
During the quarter, net losses on our Agency RMBS and negative net interest income exceeded net gains on our interest rate hedges, while our delta hedging costs remained high as a result of the elevated interest rate volatility. As a result, we had a significant net loss in the quarter. Our net interest margin increased to 1.24% from 0.93% quarter over quarter due to higher asset yields resulting from continued portfolio turnover. The increase in our NIM drove the sequential increase in ADE despite lower average holdings in the third quarter.
We also 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. Payouts on our specified pools increased slightly to 1.02% as of September 30, from 0.98% as of June 30.
Please turn now to our balance sheet on slide 6. Book value was $7.2 per share at September 30, as compared to $8.12 per share at June 30. Including the $0.24 per share of dividends in the quarter, our economic return was negative 10.6%. We ended the quarter with cash and cash equivalents of $40 million, down slightly from $43.7 million at June 30.
Next, please turn to slide 7, which shows a summary of our portfolio holdings. Our Agency RMBS holdings declined by 11% to $791 million as of September 30, compared to $889 million as of June 30. This decline was driven by principal paydowns, net sales, and net losses. Our Agency RMBS portfolio turnover was 19% for the quarter. Over the same period, our aggregate holdings of non-Agency RMBS and interest-only securities increased slightly. These positions had a positive contribution to EARN's results, driven by net interest income and net gains.
We also added $3.8 million of CLOs during the final week of the quarter, and we expect that CLO allocation to grow potentially significantly. Our debt-to-equity ratio adjusted for unsettled purchases and sales decreased to 7.3 times as of September 30, as compared to 7.6 times as of June 30. The decline was primarily due to a decrease in borrowings on our smaller Agency RMBS portfolio, partially offset by lower shareholders' equity. Over the same period, our net mortgage assets-to-equity ratio increased slightly to 7.1 times from 7 times as a smaller net short TBA position and a decline in shareholders' equity more than offset a smaller RMBS portfolio.
Finally, on slide 9, you can see the 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, US Treasury securities, and futures. As we sold Agency pools during the quarter, we covered most of our short TBA position hedges, and so we ended the quarter with a relatively small net short TBA position.
I'll now turn the presentation over to Mark.
Mark Tecotzky
Thanks, Chris. Larry already articulated many of the challenges for Agency RMBS for the quarter that led to our negative return of violent rate move, fears of money manager and mortgage REIT [selling], lots of daily rate volatility that had to be delta hedged, just to name a few of those challenges. Following quarter-end, the underperformance of Agency RMBS continued for the first three weeks of October, but markets have since reversed course quite a bit. As of Friday, they earned fourth quarter-to-date economic return at approximately negative 1.7%.
You'll only need to look at slide 3 to get a sense of just how big the price movements in the quarter were. Some 30-year coupons were down over 5 points. It's important to remember that when you get into a real bear market for anything, prices often get to places that have nothing to do with fundamental value. After extreme downward price movements, certain investment vehicles become forced to sell assets to handle redemptions or margin calls, which can cause prices to spiral downward to distress levels.
And since Agency RMBS are a lot more [liquid than almost anything of structured products] they are often the first thing these vehicles sell. As an investment manager in a situation like this, your top priority is to preserve value by avoiding becoming a distressed seller yourself. EARN did just that in the third quarter. This allowed our portfolio to participate in the significant market recovery of the last 2.5 weeks, but in any quarter with a lot of price volatility, the returns on a levered Agency strategy are driven by price changes and not spread income, and we had significant unrealized losses.
On slide 10, you can see that we kept our mortgage exposure roughly constant during the quarter. You can see on slide 8 that we have most of our mortgage exposure in the middle of the coupon stack that reduces our mortgage exposure to bank and money manager selling of lower coupons while preserving our ability to perform if economic numbers weaken and interest rates decline, which we have observed since the third week of October.
Meanwhile, we continued to turnover our Agency portfolio by adding -- to add relative value and to boost ADE, replacing pools purchased at lower interest rate environments with pools that have today's higher yields. And that was that continued portfolio turnover that drove our ADE higher this quarter. We also continue to lean on our research team to find discount pools with incrementally faster prepayment speeds and to find par coupons that we think will provide call protection in an interest rate rally.
Larry mentioned it, but I want to share some additional thoughts about allocating a portion of our capital to higher-yielding CLOs. EARN is an Agency RMBS focused suite, of course. But we think it makes sense to add some diversification with other investment sectors and we have plenty of room on our REIT test to -- for us to buy some non-REIT qualifying assets.
Historically, we have supplemented EARN's Agency strategy quite successfully with non-Agency RMBS. And while that's been a relatively small allocation for us, those non-Agency investments have been a beneficial diversifier and have performed extremely well for us, including this past quarter. Still just like Agency RMBS, non-Agency RMBS cash flows also come from single-family mortgage payments with the addition of CLO mezzanine debt and equity to our list of targeted assets. Yet we have the opportunity to add some additional diversification benefits in a non-real estate sector, and we believe that this will result in higher returns for EARN over time.
CLOs offer a good balance to Agency RMBS. CLO mezzanine debt tranches are floating rate, while our Agency RMBS are almost all fixed rate. So big swings in interest rates, which often negatively impact Agency RMBS should have much less effect on our CLO portfolio. A flat yield curve, like what we saw in the third quarter generally dampened investor demand for Agency RMBS, but they can be very positive for CLO performance.
We also see diversification benefits from a portfolio leverage perspective, Agency RMBS with very low financing costs, but also lower asset yields requires several turns of leverage to drive attractive dividend yield. On the other hand, CLO mezzanine debt and equity tranches with their much higher asset yields require much less leverage to help drive attractive dividend yield. Moreover, we can simply borrow a bit more on our Agency RMBS portfolio to help fund many of our CLO purchases, especially given the relatively modest amount of leverage and disciplined interest rate hedge that we employ in our Agency strategy.
I believe that by adding CLOs to our portfolio, we will reduce our quarter-to-quarter book-value swings during times of increased interest rate volatility. CLOs may introduce price volatility in times of heightened credit concerns, but the vast majority of EARN's current holdings have no credit risk at all. So we view the introduction of some incremental credit risk with the benefit of much higher expected returns on equity as a diversification move that makes a ton of sense.
Given their high expected yields, the CLO mezzanine debt and equity we are buying will generate very significant ADE. So we expect our allocation to CLOs to be very supportive EARN's ADE and dividend going forward. Ellington has a strong team and a great track record investing in secondary CLOs in a wide variety of vehicles. This is one of the many benefits that Ellington brings to the table as an external manager with broad capabilities. A small internally managed mortgage REIT would have a much harder time adding complementary strategies like this.
As excited as I am to be adding CLOs, I'm still very constructive by the Agency RMBS right now. While spreads are well off their October wides, they're still very wide in historical basis. And I believe that our levered Agency strategy will generate not only significant ADE, but also significant book value appreciation as spreads normalize.
New origination volumes are low due to the lock-in effect and volumes are heading even lower with winter seasonal. Now that treasury yields seem to be back in a range, I expect fixed-income flows to improve significantly from the September and October outflows. And I suspect that many banks will begin to buy Agency RMBS again.
Agency RMBS look very attractive relative to corporate bonds and treasuries, and that should draw significant incremental capital to the sector. Given the current composition of our portfolio, we actually don't have much prepayment risk. And meanwhile, the yield spreads on our assets should enjoy strong support given the concerns over a slowing economy and the expectations of significantly less active Federal Reserve.
Finally, almost [volatile] days and weeks of 2023 might be behind us, we will remain disciplined managing our interest rate risks as always.
Now back to Larry.
Larry Penn
Thanks, Mark. The third quarter was one of the toughest quarters we've seen for Agency RMBS in recent times. Following quarter-end, market conditions actually worsened in October. But so far November, markets have again reverse course, with long-term rates dropping and Agency RMBS spreads recovering somewhat. From an economic return perspective, we estimate that EARN is down approximately $0.12 so far for the fourth quarter.
The Fed funds futures market now predicts that the Fed won't increase rates for the next few meetings. And if, as expected, that leads to more normal levels of volatility, the prospects look good for capital flow back into Agency RMBS. Moving forward, I like having a lot of dry powder in this market, given the opportunities we are seeing, not only in Agency RMBS, but also in CLO mezzanine debt and equity.
I'd like to reiterate how excited I am for EARN to have added to its mandate, the secondary market corporate CLO strategy, which Ellington has been so successful in deploying over the years in other investment vehicles. Since quarter end, we have continued to add higher-yielding CLO assets to EARN's portfolio, and I expect us to continue to add more CLO assets to EARN's portfolio in the coming quarters. We will continue to be opportunistic as we think about sector allocation. As always, we will rely on our dynamic hedging strategy and active management to protect book value.
With that, we'll now open the call to questions. Operator, please go ahead.
Question and Answer Session
Operator
(Operator Instructions)
Crispin Love, Piper Sandler.
Crispin Love
Thanks. Good morning, everyone. First off on the CLO investments, are you putting on any leverage here with those investments, and can you just detail the gross and levered returns you might expect? And then just over time, how large do you think CLOs could become as a percent of your total investment portfolio?
Larry Penn
Sure. Okay. So, I don't think we've put on any leverage against the CLOs yet explicitly, although we certainly would intend to put a modest leverage on those. I think as we mentioned in the prepared remarks, we can just borrow a little bit more against our Agency portfolio for now. And that would help finance even some of the incremental CLO purchases at a much lower cost of funds. So I think that's in the near term, probably what we'll do more of. But whatever you'll see, I think by the time the fourth quarter is over, I think you'll see a little bit of leverage in that portfolio.
In terms of how big an allocation we can make to the sector, I think if you look at the current constraints that we're operating under, I mean you could -- in theory, it could get to even a 30% risk capital allocation. I mean, and I'm talking about risk capital, which is a term that we use here internally -- obviously that's not assets -- given these are so much less leveraged in terms of how you would finance those. But yeah, I could see -- theoretically, I think we could go that high. Of course, we just started. So we'll just take it slowly and see how it goes.
Crispin Love
Okay.
Larry Penn
Mark, you want to elaborate on that?
Mark Tecotzky
No, I think that was a good summary, Larry.
Crispin Love
All right. Thanks, Larry. And then Mark, can you just give us an update on your outlook for Agency spreads here, definitely remain cheap, but bit volatile in October, have tightened a bit since the kind of October 25, 26 range. But curious on your outlook just in this environment.
Mark Tecotzky
Yeah. So I think long term, there's some pretty significant tailwinds for Agency RMBS. One is that with the Fed funds futures market is right and you have a Fed that's kind of sitting on their hands for a few months, then you might get lower levels of interest rate volatility, which I think will be a catalyst for more capital flow into the sector. Also too, we mentioned banks which are typically significant buyers of Agency RMBS have been net sellers this past year. Now, a lot of that came in March with the seizure of a Silicon Valley Bank.
And if you look at what happened recently, what you've seen is just kind of paydowns on their Fannie, Freddie portfolio. So not really net selling but shrinking through paydowns, but (technical difficulty) on the Ginnie portfolio. So I think that you might get -- and we mentioned this in the prepared remarks, I think it's probably more likely than not you're going to see better plan sponsorship in Q4 than what you saw in Q3. The spreads are wide. Fixed income yields, while we're off the high of the year, you got to 10-year 5%; they're still pretty high. So I think that's going to be supportive of fixed income flows.
So I think, over a longer term, I think Agency RMBS on a levered basis, we're going to deliver significant levered ADE as well as price appreciation. So we're constructive on them. In the -- but with the CLOs, we see an opportunity to add diversification in the sector that we're very good at. It has significant yield to it. There's a lot of opportunities and for all the reasons I mentioned in my prepared remarks, it's a very good complement to Agency RMBS. The two things are sort of like parallel universes, the risks that drive them, the leverage required, the interest rate risk they have. So I think it's a good complement.
Larry Penn
Great. I just wanted to add, Chris, but I think I didn't answer your question about expected returns in that sector. So one thing that I think with in Agency RMBS, right, you -- the way we typically managed portfolio and many others as well is that you lever up net interest margin and we hedge interest rate risk and then depending on the level of volatility, you give some of that levered them back in the form of, you call, delta hedging costs or other types of volatility related frictions.
So one nice thing about CLOs is that the durations don't move around a lot. So the returns that we're seeing, which are -- with just a modest bit of leverage in the high teens, if not higher, I think. There could be some erosion there, but we really think that those -- that's what we're hoping for in the sector. And that can make a very significant difference obviously, as that allocation increases in that sector.
So and I think we mentioned that. The bit of money that we put to work already, we are projecting that it's going to achieve that. Those types of returns as well. Currently, projecting over 20% on a lot of the investments we've made so far. And, well EARN is small, it's nimble. It can buy to accumulate smaller pieces. So I think I'm very optimistic.
Crispin Love
Okay, great. And just one last question from me. Just looking at the end-of-period and average share count in the quarter, you've issued some shares here. So can you speak to the strategy there, just with the trading at a discount to book and just (multiple speakers) --
Larry Penn
Yeah. Right. We're trying to maintain $100 million of equity. And we -- this is a really tough quarter and we gave some of that back. So I think of that as kind of replacing the equity that we lost. And if yes, I think as long as we can maintain -- have some quarters going forward, including this quarter that aren't as brutal as the last quarter, I don't think you'll necessarily see as much of that.
Keep in mind also though, that with our expense ratios, which are not -- they're certainly not high for the sector, and given our size --. But given those expense ratios, it does make a lot of sense to raise capital through ATM modestly with some degree of dilution because when you look at it in terms of the accretive effect it has on earnings per share through reduction of your G&A expense ratios, it's a relatively short payback period.
Crispin Love
All right. Thanks, Larry and Mark. I appreciate you taking my questions.
Operator
That was our final question for today. We thank you for participating in the Ellington Residential Mortgage REIT third quarter 2023 earnings conference call. You may disconnect your line at this time and have a wonderful day.
