Q4 2019 Earnings Call
Ladies and gentlemen, the C. Operator today's conference is scheduled to begin momentarily until that time Airlines will again be placed on music cold. Thank you for your patience.
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It is now my pleasure to turn the floor ever to Jason Frank Deputy General Counsel and Secretary, Sir you may begin.
Thank you and welcome to Ellington residential fourth quarter 2019 earnings conference call 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.
Describe another item one <unk> annual report on form 10-K filed on March eight 2018 forward looking statements are subject to a variety of risks and uncertainties that caused the company's actual results to differ from its beliefs expectations estimates projections. Consequently, you should not rely on these forward looking statements as predictions of future events.
Statements made during this conference call are made as of the date of this call and the company undertakes no obligation to update or otherwise.
Any forward looking statements, whether as a result of new information future events or otherwise.
Joining me on the call. They are Larry Penn Chief Executive Officer of Ellington residential Mark Tecotzky, Our co Chief investment Officer, Encrypt Smart off our Chief Financial Officer.
As described in our earnings press release, our fourth quarter earnings Conference call presentation is available on our website from beef dotcom. Our comments. This morning, we'll track the presentation. Please note that any references to figure for this presentation are qualified in their entirety by the end that was at the back of the presentation with that I will now turn the call over to Larry.
Thanks Jay.
Good morning, everyone.
We appreciate your time and interested Ellington residential I.
On our call today, I'll begin with an overview of the fourth quarter.
Next Chris will summarize our financial results and then Mark will review the performance of the agency RMBS market during the quarter.
Portfolio positioning at a market outlook.
Finally, I'll provide some brief closing remarks before we open the floor to questions [noise].
[noise] Accommodative monetary policy continued globally in the fourth quarter.
Third rate cut from the Federal reserve.
Work in Central Bank, restarting asset purchases and additional policy support in China.
Domestic equity index is set new record highs and overall market volatility was love with the VIX hitting its low point for the year in November and the tenure U.S. treasury yield confined to a relatively narrow 41 basis point range during the quarter.
Yield spreads in most fixed income sectors Titan during the quarter, particularly in December.
Interest rates drifted up slowing prepayments in November and December and the yield curve steepen modestly going into year end, which you can see on slide three of the deck.
All of these factors provided substantial support for agency MBS and indeed during the fourth quarter. The agency MBS sector posted its largest excess return relative to U.S. treasuries in more than three years.
To capitalize on the value that we had seen in the agency mortgage basis coming into the quarter. We deliberately maintained relatively low level of TBS short positions in our hedging portfolio and so we were well positioned to benefit from the strong performance of agency MBS in the fourth quarter.
As you can see on slide four Ellington residential generated net income of 78 cents per share for the quarter generated an economic return of 6.2% and group book value considerably quarter over quarter.
You got strong performance from both our long holdings as well as our interest rate hedges as medium and long term interest rates rose quarter over quarter.
Core earnings increased four cents sequentially to 23 cents per share in the fourth quarter, while core earnings continues I'm, sorry, and while core earnings continues to run below our dividend rate, we believed that the prospects for expanding net interest margin and growing core earnings remain strong.
With LIBOR rates declining and repo spreads tightening our borrowing costs continue to fall as we reset our short term repos and asset yields remain attractive.
Please note that for the sake of simplicity and focus we're now presenting only one measure of core earnings rather than to.
I'll now pass it over to Chris to describe this particular change and to review our financial results for the quarter, Chris. Thank you Larry and good morning, everyone. Please turn to slide six for somebody to parents financial results.
For the quarter ended December 30, Onest 2019, we reported net income of $9.7 million or 70 cents per share in core earnings of $2.8 million for 23 cents per share.
These compared to net income of $3.7 million or 30 cents per share in core earnings of $2.4 million or 19 cents per share for the third quarter.
Our strong net income resulted from excellent performance from both our long portfolio and interest rate hedges.
You can see here on slide six that in addition to the carry on the portfolio, we generated $9.4 million, a net realized and unrealized gains on our RMBS and hedges.
While our core earnings improvement was driven by lower borrowing costs, reflecting both lower life or and tighter repo spreads, which more than offset lower asset yield.
As Larry mentioned, starting this quarter, we will be presenting only one core earnings metric as part of this decision we've modified our definition and calculation of core earnings to exclude the effect of the catch up premium amortization adjustment.
This new definition of core earnings merely matches the definition of what we perceive it previously presented as adjusted core earnings and so we will no longer present adjusted core earnings.
As a result, starting with Q4 and going forward you should compare core earnings against adjusted core earnings for prior periods.
These changes are intended to help investors focused on what we believe is the more useful supplemental non-GAAP financial measure when measuring and evaluating our operating performance and when comparing our operating performance that of our peers.
Similarly, net interest margin or NIM for the fourth quarter of 2019 and for future periods should be compared against adjusted net interest margin as presented in earlier affairs.
I reckon reconciliation of our core earnings to our GAAP net income can be found on slide 25, where you can see that our catch up premium amortization adjustment, which is excluded from core earnings and NIM was negative $2.5 million in the fourth quarter compared to negative $1.6 million in the third quarter.
During the fourth quarter actual an implied volatility was low specified pools performed well and agency RMBS yield spreads tightened as prepayment rates declined in November and December.
In addition, even though medium and long term interest rates rose quarter over quarter PPIF center specified pools increased.
Typically pay ups will weaken compared to tbds and an increasing interest rate environment, because they reflect the incremental prepayment protection that specified pools provides but that didn't happen in the fourth quarter.
Average tabs on our specified pools increased to 2.05% as at December 30, Onest from 1.86% as of September Thirtyth.
Finally, the quarter over quarter increase in medium and long term interest rates generated significant net realized and unrealized gains on our interest rate hedges.
Also on slide six you can see that our net interest margin for the quarter was 1% the average yield on our portfolio declined eight basis points to 3.13%, while our cost of funds decreased 27 basis points to 2.13% driven by declining live or and tightening repo spreads.
Notably repo rates were steady at year end, which indicated that efforts by the federal reserve, Steve was that more market more successful.
At the ended the fourth quarter, our book value per share was 12091 cents, a 49 cents from the prior quarter.
Our economic return for the quarter was 6.2%.
Next on next please turn to slide seven which shows a summary of our portfolio holdings as at December 30, Onest 2019, RMBS portfolio increased slightly to $1.402 billion as of December 30, Onest as compared to $1.395 billion as of September Thirtyth.
Turnover in our agency RMBS portfolio was 5% for the quarter as compared to 15% in the prior quarter.
Our debt to equity ratio at the ended the fourth quarter adjusted for unsettled purchases and sales was 8.1 to one decreased from 8.6 to one as of September Thirtyth.
Next please turn to slide eight for details on our interest rate hedging portfolio.
For the fourth quarter, our interest rate hedging portfolio consisted primarily of interest rate swaps short positions and CBS and U.S Treasury futures.
TVN short positions represented 13.6% over hedging portfolio at the ended the fourth quarter as compared to 11.3% at the end of the prior quarter.
Turning to slide nine you can see that our net long exposure to RMBS increased slightly so did our equity and as a result, our net mortgage assets. The equity ratio declined slightly to 7.6 to one from 7.7 to one.
I'll now turn the presentation over tomorrow.
Thanks, Chris I'm very pleased with the earns performance during the fourth quarter and for the full year for 2019 earn had an economic return to substantially exceeded the performance of a generic levered MBS mortgage portfolio, but without exposing shareholders to directionally interest rate risk to prove my point note the Bloomberg.
Please MBS total return index had excess return over treasuries have only 60 basis points for the year.
Seven or eight turns of leverage that implies returns between six and 7%.
Contrast, earns economic return was more than double that at 14.6.
In the fourth quarter alone, we had an economic return over 6% as in previous years. Our returns were driven by superior security selection and Thats off one dynamic hedging strategy designed to protect book value from drawdowns caused by rising interest rates are volatility while simultaneously putting us in position to take advantage of mark.
Patients.
We entered the year with the tenure noted to 68.
And the fed, saying, we were a long way from neutral and we ended the year three easing later with the tenure note 192 with the fed seemingly content to some their hands for long time.
The sharp drop in interest rates and bouts of volatility necessitated dynamic hedge adjustments, which we see as a primary strength of ours.
Prepayment risk made a similar you turn the refi index started the year below 1000 and climbed to 2700 by this summer.
Prepayment protection went from being an afterthought to a must have and this result, the pay ups of our specified pools quickly we priced substantially higher while the path of rates is unpredictable the relative value opportunities. We are tremendous earn was able to avoid land mines and deliver solid performance.
Many of the teams that we have discussed at length in previous years rounded to find the market dynamics in 2019.
Which I'll get into now first prepayments went from the wet blanket environment from the past couple of years go full fledged rifai wave in 2019, lower mortgage rates for the obvious driver, but technological changes from the G fees, such as Fannie Mae's day, one certainty program also contributed significantly to prepayment speeds are.
Recognition of the implications of the technological changes played a big part in driving our portfolio positioning.
Look at Slide 18, we kept our prepayment protection in place even when it wasn't popular.
For the entire year and even the beginning of the year when the refi index was below 1000.
We recognize that prepayment protection was consistently undervalued and if rates were to rally enough prepayment speeds would shoot up and so would the value of call protection, which would re price even higher than it hadn't years pattern.
Turning to slide 10, the shows that 30 year mortgage rate during the second half of 2016 in 2019.
For 2016, the three month moving average troughed at 3.4 or 5% well in 2019. It only got is lowest 3.62% within 15 basis points higher but now turn to slide 11, and let's compare the speeds in these two periods here, we are comparing the worst to deliver 30 year Fannie Mae.
Fourth in each period, which are the kind of pools you'd expect to get delivered from a TV a contract.
Well despite higher mortgage rates in 2019, then 2016 prepayments speeds are actually significantly faster in 2019.
As a result, the pay up differential between specified pools and PVA skyrocketed. Another consequence of the speed was that the dollar roll levels plummeted <unk> dollar rolls are generally price to the cheapest to deliver where essentially the worst pools. We predicted this prepayment behavior based on the improvements in technology in the mortgage market and accordingly.
And ourselves short dollar rose via our net short TBA position, which was a great way to control interest rate risk.
Another core view, we had that really helped our Q4 results was that coming into the quarter mortgage spreads look pretty good on absolute basis, but they looked very good on a relative basis.
Investment grade and high yield corporate bond spreads have tightened dramatically during the year far out performing agency MBS.
We held the strong view that a long term interest rates March tiring, Q4, and prepayment risk subsided mortgages would outperform treasuries and swaps that's exactly what happened in Q4, many of our holdings actually went up in price during the quarter, even though interest rates crimes and current coupon MBS prices dropped during the quarter.
You can see just on slide six.
We had gains on both our RMBS and gains on our interest rate hedges. So the yield spread tightening that our mortgage is more than offset the interest rate increases as Chris mentioned pets are specified pools actually increased during the increase in long term interest rate and the shows just how undervalued our pay ups were coming into the quarter.
So given Q4 performance how to things look now.
Well I would just looked pretty good but not as attractive as it started Q4, the nearly 30 basis point drop and 30 year mortgage rates. We have seen so far in 2020 has caused a Wi Fi index to pick back up so prepayment risk is clearly back in play and the seasonal downturn speeds will soon swing to a seasonal upturn speeds.
Repo financing terms have improved materially from Q4, and we think that these improved financing terms.
Our here to stay because the are result of systemic actions by the fed designed to keep repo rates tracking the fed funds rate. We think this could add five to 10 basis points on a nominal that interest margin to agency mortgages. So it's much is 80 basis points of return on a levered basis relative value opportunities abound, we are focused on delivering meaningful returns.
To our shareholders in 2020 now back to Larry.
It's mark.
I'm extremely pleased with Ellington residential is performance in 2019.
Slide five plus some of the highlights.
Thanks to our discipline interest rate hedging an active portfolio management, we successfully navigated a surgeon prepayment rates and several periods of volatility during the year and delivered economic return of 14.6%.
Remember, we did that while keeping our interest rate duration very loud throughout the entire year. So we believe that this was not only a high return, but an extremely high quality returns.
Looking forward to 2020, I really like how were positioned im excited about the investment opportunities we're saying.
Lower funding costs are improving our prospects for margin expansion and core earnings growth and despite tightening in Q4 yield spreads are still attractive relative to hedging instruments and they look, especially attractive on a historical basis relative to investment grade corporate bonds.
What our portfolio was not only fundamentally attractive it's also extremely liquid.
This is especially important given where interest rates currently are.
The 30 year Treasury yield is flirting with all time lows as is the 30 year mortgage rate.
The MBA refinancing index just hit a six plus your high.
Keeping our portfolio liquid is a conscious choice we've made at Ellington residential precisely so that we have the potential to take advantage of extraordinary market opportunities such as could be presented an extreme refinancing wave.
For example, we're very light on Io product right now and we'd love to add on significant weakness. If we were to see distressed prepayment driven selling in that market.
In summary in 2019, we again demonstrated our ability to generate strong and steady returns and the diversity of market environments, including periods of volatility enough stability rising and falling interest rates and widening and tightening yield spreads in 2020, we see a market environment that we believe plays to our strengths.
Where pool selection hedging choices in risk management will continue to drive performance.
With a highly liquid portfolio and strong balance sheet, we remain flexible and able to adapt to changing market conditions and our smaller size allows us to act quickly.
And with that we'll now open the call to your questions.
Operator.
Thank you at this time, if he would like to ask a question Press Star then the number one on your telephone keypad.
And your first question is from Doug Harter of Credit Suisse.
Oh, Thanks, I guess as as you look at kind of the market moves that we've seen so far in the first quarter I guess, where do you see the relative value in kind of the coupon sac and and given where pay ups are kind of how do you view the relative of tractor furnace of specified.
Sales versus kind of more generic collateral.
Hey, Doug it's Mark so we still like specified pools, but I guess with in the universe as specified pools.
What we like more now are some of the lower pay up stories. So you know we're not as big a fan of some of these things that are trading up three four or five points from Ta.
We have a big research effort here and we've been very focused on lot of pools or maybe the pay ups are somewhere between a core to point to a point and a half but given our analysis of the data, we think offer pretty materially prepayment protection. So.
So we still definitely prefer pain something over TB, a tick to control the quality and the attributes of what we're buying but weve rotate a little bit from.
The more popular prepayments stories, primarily loan balance into some of the other stories where.
We've been lies the data it looks like.
So were lower pay up stories are undervalued.
Great and then I guess relative you know when the coupon seems like in the first quarter. There's been no more divergence in terms of coupon performance I guess, how are you thinking about you know relative attractiveness.
Yes.
Yes, some of that gets a little bit into the specifics of portfolio positioning that we normally don't go into in the call, but I guess I would say that.
We're seeing.
You know certainly some attractive opportunities in 15 years space, which wasn't an area that you know, what's attracting a lot of our.
Pool dollars last year, but I would say across the curve. It really changes a lot you know day to day that you have seen pretty big Repricings within a week or with a two week period of time. So we kind of a consistent framework, where we look at the prepay protection and we look at.
Where the cash flows are versus swaps or treasury hedges and see what that translates into a levered NIM. So we've been.
No we cast a wide net right and so we bought things anywhere from.
Two and a half than threes up to fives in the past few months, we've seen value in all of them.
Okay I appreciate that thank you.
Thank you next question is from Mikael government of JMP Securities.
Hi, Good morning, I was wondering if you a gentleman could good morning.
Could maybe give an update on where you're seeing prepays. Thus far in the first half of the first quarter, along maybe with an update on book value.
I'll up past under Mark on Prepays are booked value.
Well.
We can talk generally about.
What's happening in mortgage basis, but I wouldn't want to go into any more detail than that but go ahead, yeah in terms of prepayment so the.
Prepayment report that we got the fifth business day of February that.
Showed you know as expected.
A decline in prepayment speeds from the peak, but you're starting to get that was really reflect above them higher mortgage rates than where we are now Larry mentioned in his script that the last print the mortgage index and given that that's a weekly time series and you could have make adjustments for day count and stuff that can be volatile, but the last print in the.
In the refi index was jumped up substantially right naturally reflective of sort of the current mortgage rates. So I think you've had this slower speeds. So far in the prepayment report that was received by the market business. The January and also slower speeds and what we had the end to 19.
The prepayment report that came out the first week of February we expect a prepayment report that comes out first week of March still won't show Big uptick can speed when you get to the April report, we think you're going to see.
Faster speeds and what we're in right now and that that will really be reflective of the.
Lower mortgage rates that are in the market right now.
Okay. Thank you very much for that.
And one question on operating expenses noticed.
We had a very nice quarter in terms of improvement in the.
The expense ratio from about.
So, let's say, 3.5% of average equity to maybe three in a quarter.
There were appetite to.
To drive that ratio downwards, maybe into the to handle range or how much room do you guys have.
Yeah, I'm, obviously that was a welcome.
And the job.
That gallant check was I was just thanks to some slightly lower professional fees.
But in all candor at the current cap it at our current capital base I don't see much potential for trimming that below that Gina expense ratio below 3%.
Dumb luck I mean.
This is not an S&P 500 index fund, where you're going to compare company is based on.
Based largely on those expense ratios, we'd love it to be a little bit lower.
But if you look at.
All the different decisions that were making how physicians portfolio during the month I mean, there's.
Huge divergence in the industry in terms of returns we think that are small size, obviously, one comment on that as a higher DNA expense ratio slightly higher but we think that we make up for it and you know the nimbleness of the company to react to changes in market.
And we think that in the long run.
Given our what we think is a unique strategy of keeping interest rate durations. So low I think were unique in the extent to which we do that.
And also are at times very heavy use of TV a short positions. Obviously, we were not as heavy in Tvs in the fourth quarter.
But.
Thats something if you look back to 2018 in earlier years, we were at times very heavy in that sector. So these are things that I think.
Differentiate earned from a lot of the other companies in the space and I think we'll make a big difference and will eventually lead to outperformance over market cycles, we're not going to be as we sort of said before when there's a tailwind in the mortgage market, we're not going to be.
Highest performing company in the space, but at 14.6% last year.
That.
Certainly is a is an excellent return and we think that over market cycles will will have much less volatility and a greater total return in the long run. So so yes. So I don't see much improvement from where we are now, but I think theres a lot of countervailing benefits as well.
Alright, great. Thank you very much for that much appreciate it. Thank you.
Thank you. This does conclude our conclude our Q any session for today. We thank you for your participation. Please disconnect your lines at this time and have a wonderful day.