Ellington Credit Company (EARN) has announced a strategic transformation that will shift its investment focus from agency residential mortgage-backed securities (RMBS) to corporate collateralized loan obligations (CLOs). This move aims to generate more stable, high-yielding returns for shareholders over the long term.

The company's history dates back to 2012 when it was initially formed as a real estate investment trust (REIT) specializing in agency and non-agency RMBS. However, on March 29, 2024, EARN's Board of Trustees approved a strategic shift to focus on corporate CLOs, including mezzanine debt and equity tranches. In connection with this transformation, EARN has revoked its REIT election and will operate as a taxable C-Corp in 2024. Later this year, the company plans to convert to a closed-end fund and elect to be treated as a regulated investment company (RIC) for tax purposes.

Business Overview

EARN's new investment strategy will leverage Ellington Management Group's (EMG) extensive expertise in the CLO market, which spans over a decade and encompasses a wide variety of market conditions. CLOs are asset-backed securities collateralized by portfolios of primarily below-investment-grade senior secured corporate loans. EARN will focus on acquiring CLO mezzanine debt and equity tranches, which typically offer high current yields to support strong net interest margins and adjusted distributable earnings.

Compared to EARN's previous agency RMBS strategy, the CLO-focused approach is expected to provide several key benefits. CLOs are primarily backed by floating-rate loans, which significantly reduces the need for interest rate hedging. Additionally, CLO investments generally require less leverage than agency RMBS, leading to a more stable debt-to-equity ratio. Furthermore, the CLO market remains highly inefficient in certain segments, particularly the secondary market for mezzanine debt and equity tranches, presenting EARN with opportunities to capitalize on relative value and trading strategies.

Financials

For the first quarter of 2024, EARN reported net income of $3.961 million, or $0.20 per share, and adjusted distributable earnings of $5.312 million, or $0.27 per share. This strong performance was driven by the company's growing CLO portfolio, which contributed over 40% of investment portfolio income despite representing less than 20% of average invested capital during the quarter.

EARN's net interest margin expanded to 3.03% in the first quarter, up from 2.19% in the previous quarter, reflecting the higher yields on its CLO investments. The company's debt-to-equity ratio, adjusted for unsettled trades, decreased to 4.9x as of March 31, 2024, down from 5.3x at the end of 2023, as the lower leverage on CLOs offset the higher leverage on agency RMBS.

For the full year 2023, EARN reported annual net income of $4.559 million, annual revenue of $13.008 million, annual operating cash flow of -$10.022 million, and annual free cash flow of -$10.022 million.

Liquidity

As of March 31, 2024, EARN had $22.4 million in cash and cash equivalents, as well as $57.1 million in other unencumbered assets. The company finances its assets primarily through short-term repurchase agreements, with 96% of its outstanding borrowings collateralized by agency RMBS as of the end of the first quarter.

EARN's debt-to-equity ratio, adjusted for unsettled trades, stood at 4.9x as of March 31, 2024, down from 5.3x at the end of 2023. This decline was driven by the company's growing CLO portfolio, which requires less leverage compared to agency RMBS. The company's net mortgage assets-to-equity ratio also decreased during the quarter, reflecting the shift towards a larger CLO allocation.

Risks and Challenges

While EARN's strategic transformation presents significant opportunities, the company faces several risks and challenges. The successful execution of the transition to a CLO-focused strategy is critical, and any delays or setbacks in obtaining shareholder approval or completing the conversion to a closed-end fund/RIC could impact the company's performance.

Additionally, the CLO market, although offering attractive returns, is subject to credit risk, as the underlying corporate loans may experience defaults or downgrades. EARN's ability to effectively analyze and manage this credit risk will be crucial to its long-term success.

Outlook

EARN's management is confident that the company's new CLO-focused strategy will provide more stable book value and earnings profiles, with the potential for growth in book value per share over time. The company expects to grow its CLO portfolio above $100 million while maintaining a core portfolio of liquid agency RMBS to maintain its exemption from the Investment Company Act prior to the conversion to a closed-end fund/RIC.

Management anticipates that the closed-end fund/RIC structure will enhance EARN's access to the capital markets and open more channels for growth. Additionally, the company believes that this new structure will provide an opportunity to expand its valuation multiple, as CLO-focused closed-end funds have historically traded at premiums to net asset value.

Conclusion

Ellington Credit Company's strategic transformation represents a significant shift in its investment strategy, moving away from agency RMBS and towards corporate CLOs. This bold move is expected to generate more stable, high-yielding returns for shareholders, leveraging Ellington's extensive expertise in the CLO market.

The company's strong first-quarter performance, driven by its growing CLO portfolio, demonstrates the potential of this new focus. As EARN continues to execute its transition and complete the conversion to a closed-end fund/RIC, investors will be closely watching the company's ability to capitalize on the opportunities presented by the CLO market while effectively managing the associated risks.