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spk06: Good morning ladies and gentlemen and thank you for standing by. Welcome to the Ellington Credit Company 2024 Second Quarter Financial Results Conference Call. Today's call is being recorded and at this time all participants have been placed on a listen only mode and the floor will be open for your questions following the presentation. If you would like to ask a question at that time please press star and 1 on your telephone keypad. At any time if your question has been answered you may remove yourself from the queue by pressing star and 2. Lastly if you should require operator assistance please press star and 0. It is now my pleasure to turn the floor over to Aladeed Shalai, Associate General Counsel. Sir you may begin.
spk02: 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. As described under item 1A of our annual report on Form 10K and part 2, item 1A of our quarterly report on Form 10Q, forward looking statements 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. 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 new information, future events or otherwise. Joining me on the call today are Larry Penn, Chief Executive Officer of Ellington Credit Company, Mark Tukowsky, our Co-Chief Investment Officer and Chris Murnoff, our Chief Financial Officer. We are also joined by Greg Bornstein, Head of Forbure Credit at Ellington Management Group. Our second quarter earnings conference call presentation is available on our website which we've recently changed to EllingtonCredit.com. Our comments this morning will follow that presentation. Please note that any references made on the call to figures in that presentation are qualified in their entirety by the notes at the back of the presentation. Furthermore, neither that presentation nor the call today should be construed as a solicitation of votes or proxies. Any such solicitation will only be made pursuant to a proxy statement or other appropriate proxy materials filed with the SEC and labeled as such. As a reminder, during this call we'll sometimes refer to Ellington Credit Company by its NYSEE ticker, -R-N or EARN for short. With that I will now turn the call over to Larry.
spk05: Thanks, Eladine, and good morning everyone. We appreciate your time and interest in Ellington Credit Company. The format of our call today will be a little different from that of previous calls. I'll start by discussing highlights of the quarter as I typically do. And then Chris will describe the quarterly financial results in more detail. But after that, Greg Bornstein, Ellington's Head of Corporate Credit, will join the call to discuss EARN's CLO portfolio composition and the outlook for the CLO portfolio from here. Then our Co-Chief Investment Officer, Mark Tkotsky, will provide a brief update on our rotation out of agency MBS. Finally, I'll wrap things up and open the floor to Q&A. Greg Bornstein has been running Ellington's investing activities in the corporate CLO sector since joining Ellington in 2012 across a wide variety of market conditions and for a wide array of Ellington's funds and accounts. We've included a short bio for Greg on slide three. Once EARN completes its conversion to a CLO focused closed end fund, Greg and Mike Ramos, Ellington's founder and head of all portfolio management activities, will officially be designated as EARN's two portfolio managers. We are all very excited to have these two veteran credit investors leading EARN's investment strategy going forward. As you can also see on slide three, the rest of EARN's management team will remain intact. Please turn now to slide four of the presentation and I'll begin with an update on EARN's strategic transformation into a CLO focused closed end fund. As a reminder, it was last September that we began rotating EARN's capital into CLOs and since then we've been steadily growing that portfolio as we approach our targeted conversion date later this year. Everything continues to go as planned and in early July we filed our preliminary proxy statement in anticipation of a shareholder vote at our annual meeting later this year. Subject to that shareholder vote, we will convert to a closed end fund for SEC purposes and a regulated investment company or RIC for tax purposes, thus completing our transformation from an agency mortgage REIT to a CLO focused closed end fund. We remain on track to complete all of these steps prior to year end. On slide five, we reiterate some of the anticipated benefits to shareholders of the transformation, which include better projected risk adjuster returns over the long term and enhanced access to capital markets. On slide six, we summarize Ellington's long standing experience investing in CLOs and chart the ramp up of EARN's CLO portfolio. EARN acquired its first CLOs towards the end of last September. By year end, the portfolio stood at $17 million and by March 31st, it had grown to $45 million. In the second quarter of 2024, we nearly doubled that number to $85 million. As you can see on this slide, EARN's CLO portfolio is now up to about $108 million as of last Friday. At that size, CLOs now account for roughly half of EARN's total capital allocation. Meanwhile, and as planned, we've shrunk our agency MBS portfolio significantly from $791 million last September to $531 million at June 30th. And we continue to downsize that portfolio as we acquire CLOs. But that said, until we actually complete our conversion process, we must continue to hold a core portfolio of liquid agency MBS in order to maintain our exemption from the 1940 Act. Fortunately, since we've concentrated our agency investments in liquid sectors, the cost of liquidating our agency pools to free up capital for CLOs has been very modest so far. We expect that to continue to be the case. Mark will elaborate on that later on the call. Please turn now to slide seven of the earnings presentation for the market backdrop for the second quarter. Despite some periods of market volatility, the CLO market continued to benefit from strengthening fundamentals, robust demand for leverage loans, and continued capital inflows. Corporate loan prepayment rates increased further, reaching their highest level on a trailing 12-month basis since February of 2022. That drove further de-leveraging in seasoned CLOs, which has continued to benefit earns holdings of discount dollar price CLO mezzanine tranches. However, as we illustrate towards the middle of this slide, the Morningstar LSTA leverage loan index actually ticked down quarter over quarter following six consecutive quarters of increases. This was simply the result of those high corporate loan prepayment rates in the second quarter, since many premium priced corporate loans prepaid at par. Meanwhile, high yield and IG credit indices tightened further, as depicted here as well. In the CLO market, you can see here that credit spreads on double B and single B CLO tranches tightened overall as well. But there was significant dispersion among deals with higher quality tranches generally tightening and lower quality tranches widening. The European CLO market also saw spreads tighten, particularly in higher quality mezzanine tranches. For CLO equity, tightening new issue mezzanine debt spreads were a double-edged sword. On the one hand, deals with better performing portfolios and higher debt costs were able to capitalize on those tighter spreads by refinancing or resetting their debt at cheaper levels. This activity drove strong positive returns for CLO equity in those particular deals. But on the other hand, the high volume of premium priced loan collateral refinancing at par and at lower coupon spreads led in many deals to overall declines in net asset values and compressions in excess interest. These effects triggered -to-market losses for CLO equity in many deals, as both the interest payments on CLO equity, due to lower excess interest in the CLO, and underlying asset values declined in tandem. These dynamics led to -to-market losses on some of our earned CLO equity tranches during the second quarter. Meanwhile, in the agency MBS market, yield spreads were little changed quarter over quarter, and the US Agency MBS index generated a slightly negative excess return relative to US Treasuries. But those minor changes belied the significant negative impact of -for-quarter interest rate volatility in generating delta hedging losses, which for example you've seen reflected in the weak overall performance of the agency mortgage REIT sector this past quarter. I'll turn now to Ernst's quarterly results on slide 8, and I'll begin with gap earnings. We had continued strong performance from our CLO mezzanine debt investments, both US and European, driven by both opportunistic sales and some of our discount positions being called at par. On the CLO equity side, our US CLO equity investments had -to-market losses driven by that heightened loan refinancing activity that I mentioned earlier, but our European CLO equity investments actually performed quite well. Overall, CLOs contributed positively to our net income for the quarter. In contrast, our remaining MBS portfolio contributed a modest $0.05 per share net loss for the quarter, caused primarily by that intra-quarter interest rate volatility. This drove our slight overall net loss for the quarter. Our ongoing rotation from agency MBS into CLOs continued to drive our net interest margin wider, our leverage ratios lower, and our adjusted distributable earnings higher. You can see on slide 8 that our net interest margin expanded to .24% overall, while our -to-equity ratio declined to 3.7 to 1 at quarter end. The growth of the CLO portfolio with those wide net interest margins drove the sequential growth of our adjusted distributable earnings for the quarter. Ellington credits ADE, who 9 cents per share sequentially to 36 cents per share. I'll note, however, that we expect our ADE to tick down in the near term as we continue to sell agency pools and as the associated interest rate swap hedges that we initiated in much lower interest rate environments are terminated or burn off. That said, we do anticipate that our ADE will continue to cover our dividend in the third quarter. With that, I'll now pass it over to Chris to review our financial results for the second quarter in more detail.
spk01: Chris, thank you, Larry. And good morning, everyone. Please turn to slide 9 for a summary of Ellington credits second quarter financial results. Where the quarter ended June 30th, we are reporting a net loss of 4 cents per share and adjusted distributable earnings of 36 cents per share. ADE excludes the catch-up amortization adjustment, which was positive 221,000 in the second quarter. Our overall net interest margin expanded to .24% from .03% quarter over quarter, driven by the growth of CLOs and that drove the sequential increase in ADE. In the second quarter, we continue to benefit from positive carry on our interest rate swaps, where we receive a higher floating rate and pay a lower fixed rate. But as Larry mentioned, we expect the impact of this benefit to decline in future quarters as some of these swaps expire and as we sell down the agency portfolio and take off the associated hedges. Slide 10 shows the attribution of income by strategy. In the second quarter, the CLO strategy generated 5 cents per share of portfolio income driven by strong interest income, which increased sequentially due to the accelerated amortization of market discount on several discount positions. Further, net gains on our CLO mezzanine portfolio were supported by both opportunistic sales and discount positions being called. This income was partially offset by -to-market losses on certain CLO equity positions, where rapid prepayments drove -to-market losses, as well as reduced floating rate spreads on the underlying loan collateral. Our agency strategy, meanwhile, generated a portfolio loss of 5 cents per share for the second quarter. In April, interest rates and volatility increased over renewed concerns about inflation and a more hawkish federal reserve, which pushed agency RMBS yield spreads wider. In May and June, however, interest rates and volatility generally declined and agency RMBS yield spreads reversed most of their April widening. Overall, for the second quarter, the U.S. MBS index generated an excess return of negative 9 basis points to Treasuries. Against this backdrop, earned agency portfolio generated a small net loss for the quarter, as net losses on our agency RMBS exceeded net gains on our interest rate hedges, and that drove earned overall net loss for the quarter. Our non-agency portfolio performed well during the quarter, generating 4 cents per share, driven by net interest income and net gains associated with several profitable sales. In connection with our strategic transformation, we revoked the re-election effect of January 1st of this year and are currently operating as the taxable C-Corp. We came into the year with substantial net operating loss carry forward, and in the first quarter we used a portion of those to offset the majority of our federal taxable income. In the second quarter, our overall net loss generated a modest tax benefit and did not require the utilization of any of our NOLs. Please note that we are not booking a deferred tax asset on our balance sheet related to the NOLs, so our reported book value remains fully tangible. After our conversion to a closed-end fund regulated investment company, we will generally not be subject to corporate income tax. Please turn now to our balance sheet on slide 11. Book value per share was $6.91 at June 30th compared to $7.21 at March 31st. Including the 24 cents per share of dividends in the quarter, our economic return for the quarter was a negative 0.8%. We ended the quarter with $163 million in cash and unencumbered assets, of which included $90 million of U.S. Treasury bills held on margin. Next, please turn to slide 12 for a summary of our portfolio holdings. During the second quarter, our CLO portfolio increased to $85 million as of June 30th compared to $45 million as of March 31st. At June 30th, CLO equity comprised of 47% of our total CLO holdings, up from 25% at March 31st. Meanwhile, European CLO investments comprised 17% of our total CLO holdings at June 30th, up from 10% at March 31st. Also during the second quarter, the size of our agency RMBS holdings decreased to $531 million as compared to $739 million as of March 31st. And our aggregate holdings of interest-only and securities and non-agency RMBS decreased as well. Including activity through August 9th, our agency RMBS portfolio have now declined to $518 million, while our CLO portfolio has grown to approximately $108 million. As measured by allocated equity as opposed to gross assets, our capital allocation to CLOs increased to 45% at June 30th, from 25% at March 31st and 11% at year end. Our -to-equity ratio adjusted for unsettled trades decreased to 3.7 times as of June 30th compared to 4.9 times as of March 31st. The decline was driven by less leverage on our CLO investments as well as higher shareholders' equity. Similarly, our net mortgage -to-equity ratio decreased over the same period to four times from 5.4 times. Finally, on slide 14, we provide details of our interest rate hedging portfolio. During the quarter, we continued to hedge interest rate risk primarily through the use of interest rate swaps. The overall size of our interest rate hedging portfolio declined -over-quarter as the share of our portfolio and CLOs increased. As shown on slide 15, we ended the quarter with a net-long TBA position both on a notional basis and as measured by 10-year equivalents as compared with a small net-short TBA position in the prior quarter. On slide 16, you can see that nearly all of the loans underlying our CLO portfolio are floating rate and as such have much lower interest rate duration. I will now turn the presentation over to Greg.
spk03: Thanks, Chris. I'm happy to be speaking to EARN shareholders today and I'm very excited to become your co-portfolio manager with Mike Franos going forward. I'll first talk about how we've ramped up CLOs in EARN over the last 10 months and then get some thoughts about how we see the portfolio evolving from here, including some thoughts on the recent volatility. Back in September when EARN first began acquiring CLOs, CLO credit spreads were very wide. They had significantly lagged the recovery in the high-oil corporate bond market and credit spreads on certain CLO Mez tranches available in the secondary market had backed up to levels we hadn't seen since mid-2020. Meanwhile, credit fundamentals were strong and getting stronger. We saw a great risk-adjusted return opportunity in CLO Mez and started building a portfolio. Through March 31st, the majority of our CLO investments were in CLO Mez. Credit spreads for CLO Mez have since tightened considerably. We've actively traded some positions to monetize gains. We've been called out of others that we held at significant discounts to par. And we also have -to-market gains on numerous positions that we still hold. This dynamic has driven strong returns in EARN's overall CLO strategy so far. Fast forward to the second quarter and those tighter CLO debt spreads really enhance the attractiveness of CLO equity. Tighter new issue debt spreads lower the implied financing cost of CLO equity and they also enable certain CLO equity holders to refinance or reset their liabilities, which further enhances the cash flow profile of those deals from the equities perspective. For those reasons, you saw the majority of our new CLO purchases in the second quarter were in equity as opposed to Mez. And at quarter end, the split is just about 50-50 between Mez and equity. Going forward, I expect our portfolio to continue to be a blend of Mez and equity with the mix fluctuating based on market opportunities. We've also supplemented our core US CLO portfolio with European CLO Mez and equity investments. We've often found investment opportunities in European CLOs offer compelling relative value versus what we see in the US. And having an allocation to the European sector also provides some valuable portfolio diversification. Ellington has been investing in European CLOs for a decade and they work with our dedicated investment professionals in our London office who analyze and trade the product day to day. Our investment teams in the US and Europe follow the same investment processes and risk management principles and are ultimately overseen by Mike Branos and me. In both markets, we are systematic in our evaluation of potential investment opportunities, including deep dives on credit analysis and detailed review of deal documentation. Mike Branos and I plan to continue to allocate earned capital to Europe opportunistically based on where we see relative value, but I expect by and large the majority of our CLO investments to continue to be in the US. As for the volatility of the past couple of weeks, while credit spreads have certainly widened overall, I'll note that markets for CLOs by and large have been orderly even on the most volatile days as compared to some of the acute periods of panic we saw in other sectors earlier this month. The volatility has created some attractive trading opportunities as it typically does, and we were able to play offense during the sell-off and deploy some of our dry powder at attractive spreads. We've also had some credit hedges in place through the recent period, which we use to help stabilize book value per share and protect against tail events. Since there is often a lag between price action on our credit hedges and price action on our assets, being able to dial up and down our credit hedges adds another dimension to potentially enhance returns. On the balance, while the recent volatility might lead to some third quarter -to-market losses and part of earned portfolio, I also see this volatility as recharging an opportunity set and providing an exciting environment for trading, which plays into Ellington's strengths. With that, I will turn the presentation over to Mark.
spk07: Thanks, Greg. While Q2 is generally a good quarter for spread product, it was actually a weak quarter for agency MBS. There was a lot of interest rate volatility to manage, and continued bank portfolio restructurings added MBS supply to the market, which exacerbated volatility further. As we mentioned on last quarter's earnings call, we've laid out a clear set of priorities as we manage our investment transition from an agency MBS focus to a CLO focus. During the quarter, we stuck to our plan and made very good progress with that transition. During the transition, while we have been focusing on acquiring attractive CLO investments, we have also been focusing on minimizing the cost of liquidating our pools, all while staying invested in the combination of agency MBS and CLO investments that we expect to generate strong total returns and ADE in excess of our dividend. During the quarter, we shrunk our agency portfolio by nearly 30%. As we continue to sell off MBS, we are maintaining a focus on liquidity for our remaining MBS portfolio. That has meant, for example, that we no longer own 15-year pools, which are typically much less liquid than 30-year pools. We also have very few Gini-May pools for a similar reason. We've also reduced our pay-up risk by shedding higher pay-up pools. Our average pay-up declined by over 25% in the second quarter, and that has also improved liquidity of the remaining portfolio. Meanwhile, prepayment risk is higher now than it was earlier in the year, so we need to manage our MBS investments with that in mind as well. Like many things, the key to the plan has been execution. Despite some weak agency MBS performance, we picked our spots, sold a meaningful part of the agency pool portfolio, and yet our MBS portfolio still almost broke even in what was a down quarter for the sector. We continue to focus on raising cash for new CLO investments while minimizing book value impairment. This process is ongoing in Q3, but things are a little different now. In the second quarter, credit spreads generally ground tighter, and Greg discussed how that impacts our CLO holdings. More loans trading above par, higher voluntary loan prepayment speeds, more refinancings, and more resets. But in the last two weeks, we got a real jolt of volatility and some meaningful yield spread widening in many parts of the credit market. I think that's generally good news for us. We have dry powder and are aggressively looking to add to our holdings. Our relative value approach to CLO investing often finds the best investments when the market is repricing quickly. Looking ahead, I think both portfolios are set up to deliver strong returns. A steeper yield curve and the prospect of September rate cuts is generally a good backdrop for agency MBS, and recent widening in CLO spreads should create an attractive entry point as we continue to grow our portfolio. Now, back to Larry.
spk05: Thanks, Mark. The CLO strategy again outperformed agency MBS in the second quarter, as it's consistently done since EARN began investing in the sector last September. In particular, I'm pleased to have sold several CLO MEZ positions and to have several discounted positions pay off at par, all ahead of the recent market volatility we've seen this past week or so. These moves locked in gains when spreads were tighter, and they also freed up additional liquidity. We finished the quarter with plenty of cash and borrowing capacity to drive portfolio and earnings growth. That dry powder is particularly valuable given recent spread widening, especially in CLO equity. I really like having a targeted asset roster that includes both CLO MEZ and CLO equity. Those two markets don't always perform in sync. As Greg described, we saw that in the second half of 2023, when we thought there was especially good value in mezzanine debt, more so than in equity. Therefore, when we started accumulating CLOs back then, most of our acquisitions were in mezzanine debt. And we saw this kind of dispersion again this past quarter, when, as we've mentioned a few times earlier today, heightened refi activity in the corporate loan market led to stronger performance from discounted mezzanine debt, but weaker performance from CLO equity. That disparate performance leads us now to see better current relative value opportunities in CLO equity rather than CLO mezzanine debt. So we've been focusing our acquisitions recently in CLO equity. Both sectors have offered high risk adjusted returns over time, but I believe that we are able to enhance those returns even further by rotating between sectors so as to pick better entry and exit points at each step along the way. I also like having a small but flexible allocation to European CLOs. As you can imagine, that market, with its geographically distinct investor base, has technical forces that can be quite disconnected from the US CLO market. Again, this gives us the opportunity to further enhance returns by opportunistically deploying and rotating a portion of our capital into the European sector. To both capture better relative value and improve portfolio diversification, as Greg described. We remain energized as we look forward to a successful shareholder voter at our annual meeting later this year, after which we can complete our conversion to a CLO focused closed end fund slash rec. I strongly believe that our strategic transformation will generate superior risk adjusted returns for Ellington credit shareholders. I'm particularly pleased with how positive our conversations with investors and analysts have been following the announcement of the transformation earlier this year. With that, we'll now open the call to questions. Operator, please go ahead.
spk06: Gentlemen, thank you for your remarks. And to our phone audience joining today, at this time if you would like to ask a question, it is star and one on your telephone keypad. Pressing star and one will place your line into a queue and will open your lines for questions one at a time. Once again, ladies and gentlemen, that is star and one for questions today. And we'll hear first from Jason Weaver at Jones Trading.
spk09: Hi, good morning. Thanks for taking my question. First of all, I was curious on the dispersion on CLO performance that you noticed in your, you mentioned in your prepared remarks and obviously noting the refi activity. Is there anything else material that you can point to that's just that's driving that performance dispersion, whether it's due to sponsor asset class or sector concentration?
spk08: Greg?
spk03: Sure. So I think you touch upon dispersion in the assets. And if you take a look, I think you've certainly see that continue to play out this year. Equity being a first loss tranche is going to be exposed to whatever happens in the tails. And you've seen this not only in leveraged loans, but in high yield where throughout the year you generally seen more and more of the spread of the overall portfolio and the risk, you know, come from, you know, the widest most credit sensitive names. And I think that as much as you've seen sort of macro systemic moves where liability prices have come in, which it helped improve cash flows to CLO equity and the loan prices tightening where prices have moved up, you still see a bit of dispersion deal to deal in what's going to happen in the next year. And I think that's what's going on in the tails of these portfolios.
spk09: Got it. Okay. Thank you. And then, you know, we appreciate the update on the quarter date CLO additions through last Friday. But I was wondering, can you provide a similar update on liquidity and leverage quarter date?
spk01: Looking for that. Not sure we had it. Leverages ticked down. Sure. Yeah. So as of July 31st, you know, our death equity ratio was down to around three times.
spk09: Okay. Fair enough. Thank you for that. Appreciate the color.
spk06: Our next question today comes from Eric Hagan at BTIG. Please go ahead.
spk08: Hey, good morning. Thank you. A couple of questions here. I mean, how are you thinking about the dividend? Did you rotate more capital into the CLOs? And then how much more capital do you expect to maybe rotate into CLOs just between now and call at the end of the third quarter? Thank you guys.
spk05: I'll have I'll take the first part. Yeah. I mean, I think as we mentioned, the rotation is actually supporting our, you know, our net interest margin, our ADE. So we feel good about maintaining the dividend, you know, through the conversion and thereafter. So, you know, really don't have any concerns there. Now, as far as your second question, JR, you want to take that?
spk04: Sure. So, you know, when we're in this interim period as a C Corp, we need to abide by the Fortiac exemption as you know. So we have to maintain a core portfolio of agency MBS, you know, which are good assets for the Fortiac test. You know, we updated that capital was about 50-50 between CLOs and agency as of the end of last week. We gave the gross asset amount updates. We're getting closer to the point. We're not giving exact numbers, but I think it's fair to say that we said a few months ago that we plan to take CLOs over 100 million, which we've now accomplished. We're getting close to the point where we can add more on the margin and we've been able to lower leverage as Chris mentioned. And we've also added some more liquidity in July through asset sales. So we have more room, but certainly the pace of adding the seal portfolio needs to subside at this point until we effectuate the conversion.
spk05: Yeah, I think we've been adding. I mean, this is really rough, but maybe 20, a little over 20 million a month, something like that. And could we do that for two more months? Maybe. But hopefully this will all coincide with our conversion. So let's just it could be it could the timing could not to be very well. But that's give you sort of an idea, I think, of where we could be heading right before the conversion. But it but it sort of depends on a few things structurally. And it depends a little bit on on how much we finance those assets. So there's a bunch of complexities and Jay are mentioned. Whole pools are key in maintaining our 40 act exemption all in the meantime. So we're going to continue to have that core portfolio of whole pools.
spk08: OK, that's helpful and appreciate the outlook for the dividend to be stable. But I mean, shouldn't investors maybe expect the dividend to go higher at some point once the conversion is complete? Just given the return outlook for the first deal was right now.
spk05: Love the question. I think we we like to under promise and over deliver if we can. So we're just going to say for now, let's think in terms of maintaining.
spk08: OK,
spk05: appreciate you guys. Thank you.
spk06: And that was our final question for today. We thank you for your participation in Ellington Credit Company's second quarter, 2024 financial results conference called. You may disconnect your line at this time and have a wonderful day.
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