Q3 2023 Ellington Residential Mortgage REIT Earnings Call
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 at this time all participants have been placed on listen only mode and the floor will be opened for your questions. Following the presentation.
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All of the initially associate General Counsel, Sir you may begin.
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 90 to 95.
Forward looking statements are not surgical 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 to Koskey, our co chief.
Investment Officer, Christopher our Chief Financial Officer as described in our earnings press release, our third quarter earnings Conference call presentation is available on our website <unk> Dot com.
Our comments this morning will track the presentation. Please note that any references to figures in this presentation are qualified at an entirety, but the notes at the back of the presentation with that please turn to slide three of the presentation and I will now turn the call over to Larry.
Thanks, Dan and good morning, everyone.
We appreciate your time and interest in Ellington residential.
The third quarter actually began on a constructive now.
In July inflation fell to its lowest year over year pace in two years GDP growth beat expectations and U S equities and most credit fixed income sectors posted gains for the months.
Our agency MBS.
D IC selling of specified pools continue to be well digested by the market.
The U S Agency MBS index generated a positive excess return for the month over treasuries.
Earn has had a positive economic return in July as well.
The quarter got considerably more challenging from there.
Realized volatility remained high and long term interest rates continue their upward March which put significant pressure on agency yield spreads.
In particular, the federal Reserve's Hawkins from Hawkish messaging out of September meeting triggered a sell off in most fixed income sectors agency MBS included although possible government shutdown attitude and uncertainty.
The yield on the 10 year Treasury Rose 82 basis points between mid July and September 30th and the move index, which tracks expected short term interest rate volatility remained elevated.
Against this backdrop agency MBS, Gary significantly underperformed comparable U S treasuries and interest rate swaps during the quarter.
With lower coupon MBS exhibiting the most pronounced underperformance.
On slide three of the presentation, you can see that the dollar prices on Fannie two and a half three three and a half declined by more than five points sequentially.
<unk> generated an overall net loss of 75 per share for the quarter with net losses on our specified pools exceeding net gains in our interest rate hedges.
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 cost of funds remained relatively stable.
In addition, a significant portion of the losses on our agency MBS 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 continue to hold a strong liquidity position at quarter end with cash and unencumbered assets, representing 38% of our total equity.
Our leverage ratio is 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 remains 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 RMB of supply in 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 subside somewhat incremental institutional demand for agency MBS 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 <unk> capital to corporate Clo's, 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 can mean for earn going forward.
Yield spreads on certain CLO mezzanine and equity tranche is available in the secondary market or near levels. We saw last in the summer of 2020 and.
In the credit markets were still very much recovering from their COVID-19 lows.
Furthermore, no two CLO as are alike.
Rich given ellington's extensive CLO expertise should create lots of trading opportunities and relative value opportunities for us to capture.
Ellington strong and long standing track record of investing in CLO is in the secondary market should position <unk> well to capitalize on both the near term and the long term opportunity we see in this sector.
We are off to a good start as in the past six weeks or it has it has acquired several CLO mezzanine debt and CLO equity tranches, while we project returns on equity well in excess of 20%.
I believe that CLO mezzanine debt and equity.
Well with agency MBS as a complimentary strategy that will diversify and help drive 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. Thank you Larry and good morning, everyone. Please turn to slide five for a summary, Ellington residential third quarter financial results.
For the quarter ended September 30, we reported a net loss of 75 per share and adjusted distributable earnings of 21 cents per share.
These results compare to net income of nine cents per share and <unk> 17 per share in the second quarter.
<unk> excludes the catch up amortization adjustment, which was positive $46000 in the third quarter as compared to a negative $376000 in the prior quarter.
During the quarter net losses on our agency RBS 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, two 4% from zero point, 93% quarter over quarter due to higher asset yields resulting from continued portfolio turnover.
The increase in our NIM drove this sequential increase in <unk>, Despite lower average holdings in the quarter in the third quarter.
We also continued to benefit from positive carry on our interest rate.
Swap hedges, where we receive a higher floating rate and pay a lower fixed rate.
Pay ups on our specified pools increased slightly to 1.0% to 2% as of September 30th from zero point, 90% as of June 30 for June 30th.
Please turn now to our balance sheet on slide six.
Book value was $7 <unk> per share at September 30, as compared to $8 12 per share at June 30.
Including the 24 cents per share of dividends in the end.
This quarter, our economic return was negative 10 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 seven which shows this summer shows a summary of our portfolio holdings.
Our agency MBS holdings declined by 11% to $791 million as of September 30, compared to $889 million as of June 30.
This decline was driven by a principal pay down net sales and net losses.
Our agency MBS portfolio turnover was 19% for the quarter.
Over the same period, our aggregate holdings of non agency MBS and interest only securities increased slightly.
These positions had a positive contribution to earnings results driven by net interest income and net gains.
We also added $3 $8 million of CLO 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 273 times as of September 30, as compared to seven six times as of June 30.
The decline was primarily due primarily due to a decrease in borrowings on our smaller agency MBS portfolio, partially offset by lower shareholders' equity.
Over the same period, our net mortgage assets to equity ratio increased slightly to seven one times from seven times as a smaller net <unk>.
Short TBA position and a decline in shareholders' equity more than offset a smaller RMB portfolio.
Finally on slide nine you can see the details of our interest rate hedging portfolio.
During the quarter, we continued to to hedge interest rate risk through the use of interest rate swaps and short positions in TBA is U S Treasury Securities and futures.
As we saw 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.
Now I'll turn the presentation over to Mark.
Thanks, Chris.
Our radio articulated many of the challenges for agency MBS for the quarter that led to a negative return of violent rate move curious if money manager in mortgage REIT sell off.
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 MBS continued for the first three weeks of October but markets have since reversed course quite a bit.
As of Friday may earns fourth quarter to date economic return at approximately negative one 7%.
You only need to look at slide three to get a sense of just how big the price movements in the quarter were.
Some 30 year coupons were down over five 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 agent.
See MBS around a lot more liquid than almost anything else.
They are often the first thing these vehicles salad.
As an investment manager in a situation like this you are top priority is to preserve value by avoiding becoming a distress seller yourself.
And did just that in the third quarter.
This allowed our portfolio to participate in the significant market recovery over the last two and a half weeks, but in any quarter with a lot of price volatility. The returns on a Levered agency strategy are driven by price changes and that 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 eight we have most of our mortgage exposure in the middle of the coupon stack that reduces our mortgage exposure to banking money manager selling of lower coupons, while preserving our ability to perform if economic numbers weekend and interest rates decline, which we have observed.
<unk> since the third week of October.
Meanwhile.
We continue to turnover our agency portfolio by adding to add relative value went to boost a D E replacing pools purchased at lower interest rates lower interest rate environments with pools that have today's higher yields and it was that continued portfolio turnover that drove our a D E higher this quarter.
We also continue to lean out our research team to find discount pools with incrementally faster prepayment speeds and defined park coupons that we think will provide call protection and an interest rate rally.
Larry mentioned, it but I want to share some additional thoughts about allocating a portion of our capital to high yielding clo's.
Arun as an agency.
N B S focused REIT 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 tests to for us to buy some non REIT qualifying assets.
Historically, we have supplemented the earn to agency strategy quite successfully with non agency MBS and while that's been a relatively small allocation press those non agency investments had been a beneficial diversified and have performed extremely well for us, including this past quarter.
Still just like agency MBS non agency MBS cash flows also come from single family mortgage payments with the addition of CLO mezzanine debt and equity to our list of targeted assets with yet we have the opportunity to add some additional diversification benefits and a non real estate sector and we believe that this will result in higher returns for earn.
Time.
Cielo is off to a good balance to agency MBS CLO mezzanine debt tranches are floating rate, while our agency MBS are almost all fixed rate so big swings in interest rates, which often negatively impact agency MBS should have much less effect on our CLO portfolio flat.
A flat yield curve like what we found the third quarter generally dampened investor demand for agency MBS, but they can be very positive for CLO performance.
We also see diversification benefits from our portfolio leverage perspective.
Agency MBS with very low financing costs, but also lower asset yields require several turns of leverage to drive attractive dividend yields.
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 yields. Moreover, we can simply borrow a bit more on our agency MBS portfolio to help fund many of our CLO purchases, especially given the relatively modest amount of leverage and <unk>.
<unk> interest rate hedge that we employ in our agency strategy.
I believe that by adding CLO to our portfolio, we will reduce our quarter to quarter book value swings during times of increased interest rate volatility CLO may introduce price volatility in times of heightened credit concerns, but the vast majority of earnings current holdings have no credit risk at all so we view the introduction of <unk>.
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 a D E and so we expect our allocation CLO to be very supportive earns a D E and dividend going forward.
Ellington has a strong team and a great track record of investing in secondary CLO and a wide variety of vehicles. This is one of the many benefits to 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 CLO and still very constructive on the agency MBS right now while spreads are well off their October wides. They are still very wide and the historical basis and I believe that our Levered agency strategy will generate not only significant E. D E. But also significant book value appreciation as spreads normalized.
No origination volumes are low due to lock in effect and volumes youre heading even lower with winter seasonal.
Now that treasury yield 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 MBS again.
Agency, MBS look very attractive relative to corporate bonds, and treasuries and that should drive significant incremental capital to the sector.
Given the current composition of our portfolio, we actually don't have much prepayment risk and Meanwhile, the yields yield spreads on our assets should enjoy strong support given the concerns over slowing economy and the expectations of a significantly less active federal reserve finally, while the most volatile days and weeks of 2023 might be behind us.
We will remain disciplined managing our interest rate risk as always now back to Larry.
Thanks Mark.
The third quarter was one of the toughest quarters, we've seen for agency MBS in recent times.
Following quarter end market conditions actually worsens in October, but so far November markets have again reverse course, if long term rates dropping and agency MBS spreads recovering somewhat.
From an economic return perspective.
We estimate that earn is down approximately 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.
And if as expected that leads to more normal levels of volatility the prospects look good for capital slow back into agency MBS.
Moving forward I like having a lot of dry powder in this market given the opportunities we are seeing not only in agency MBS, but also in CLO mezzanine debt and equity.
I would like to reiterate how excited I am for Orange, who have added to its mandate the secondary market corporate CLO strategy, which Ellington has been so successful in deploying over the years and other investment vehicles.
Since quarter end, we have continued to add high yielding CLO assets portfolio and they expect us to continue to add more CLO assets to our 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.
Thank you at this time, if you'd like to ask a question. Please press the star and one on your telephone keypad you may remove yourself from the queue at any time by pressing star to once again it is star and want to ask a question, we'll pause for a moment.
And we'll take our first question today from Crispin Love with Piper Sandler.
Thanks, and good morning, everyone first off on the CLO investments are you putting on any leverage here.
Those investments and can you just detail that the gross Unlevered returns you might expect and then.
Just over time, how large do you think CLO could become as a percent of your total investment portfolio.
Sure Okay. So.
I don't think we've put on any leverage against the Clo's yet.
Splits, Italy, although.
We certainly would intend to put a modest leverage on those.
I think as 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 thats in the near term probably about we'll do more us.
But.
Yes.
But whatever youll see youll see I think by the time the fourth quarter is over I think youll see a little bit of leverage.
In that in that portfolio in terms of how.
How big an allocation, we can make to the sector.
I think if you look at.
The current constraints that were operating under I mean, you could.
CRE it could get to even a 30% risk capital allocation.
I'm talking about risk capital, which is.
That we use here internally.
That's on assets.
Given that these are.
So much less leveraged in terms of how you would finance those.
But yes, I could see theoretically I think we could go that high of course.
We just started so we will just take it slowly and see how it goes.
Okay.
Mark that Mark do you want to elaborate on that.
Yeah.
Okay.
No I think I think that was a good summary, Larry.
Alright, Thanks, Larry and then.
Mark can you just give us an update on your outlook for agency spreads here definitely remain cheap, but volatile in October have tightened a bit since kind of the October 25, 26 range, but curious on your outlook just in this environment.
Yeah, So I think long term.
There's some pretty significant tailwind for agency MBS.
One is that you know with the fed funds futures market is right.
And do 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 to flow into the sector.
Also two we mentioned you know banks, which are.
Typically significant buyers of agency MBS have been net sellers. This past year now a lot of that came in March with the seizure of the Silicon Valley Bank and if you look at what happened recently, what you've seen is just kind of pay downs on their Fannie Freddie portfolio, so not really net selling but shrink.
<unk> pay downs, but it didn't and 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 not youre going to see better planned sponsorship in Q4 than what you saw in Q3.
Spreads are wide fixed.
Fixed income yields while we're off the highs a year you know where you got the 10 year, 5%, they're still pretty high. So I think that's going to be supportive of fixed income flows. So.
I think you know over a longer term I think agency MBS and levered basis are going to deliver.
<unk> Levered a D E as well as price appreciation, so we're constructive on them and the.
But with the Clo's, 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 MBS are sort of like the two.
Things are sort of like parallel universes, the risks that drive them to leverage acquired the interest rate risk. They have so I think it's a good complement.
Greg I, just wanted to add Chris, but I think I didn't answer your question about expected returns.
In that sector. So.
One one thing that I think with an agency MBS right you.
The way, we've typically managed portfolio and many others as well is that you.
<unk> net interest margin.
And.
We hedge interest rate risk and then depending upon the level of volatility you gave some of that Levered NIM back.
In the form of you called Delta hedging costs or other types of volatility related frictions right. So.
One nice thing about Cielo is just 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.
Thank you.
There could be some erosion there, but we really think the dose.
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 I think we mentioned that.
It's a bit of money that we put to work already.
Yes.
We are projecting that it's going to achieve that those types of returns as well currently projecting over 20%.
The investments we've made so far.
And.
Yes, <unk>, it's small it's nimble.
It can.
Bye to accumulate small pieces, so I think.
I am very optimistic.
Yes.
Okay, Great and just one last question from me just looking at the end of period and average share count in the quarter U S issued some shares here. So can you just speak to the strategy there just with the <unk> trading at a discount to book.
Yeah. So.
Right. We're trying we're trying to maintain $100 million of equity.
And.
We this was a really tough quarter and we gave some of that back so.
Think of that as kind of replacing.
The equity that we lost and I think as long as we.
Ken.
Maintain.
Yes.
You have some quarters going forward, including this quarter.
Britain was the last quarter I don't think youll necessarily see as much is that keep in mind.
So though that.
With our expense ratios, which are not.
There are certainly not high for the sector, but.
And given our size, but but given given those expense ratios. It does make a lot of SaaS.
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.
Alright, Thanks, Larry and Mark I appreciate you taking my questions.
Yes.
Sure.
That was our final question for today, we thank you for participating in the Ellington residential mortgage REIT third quarter 2020 earnings conference call.
Okay.
Yes.
You may disconnect your lines at this time and have a wonderful day.
Okay.
Hello.
Yeah.
Okay.
Okay.
Hum.