Dividend yield-seeking investors may be attracted to Ellington Financial’s (NYSE:EFC) juicy dividend. However, I would caution investors in this regard as the high dividend yield offered by EFC is reflective of the relative riskiness of their underlying investments. I would recommend any investors long EFC to exit their positions in the stock. However, I would advise against selling EFC short because of the heavy cost of carry one would incur attributable to the company’s high dividend yield.
Review of EFC’s Operations and Profitability
Ellington Financial’s business model is relatively simple; borrow in the short-term money markets (primarily repurchase agreements), invest in consumer/corporate credit markets and agency mortgage-backed security markets, and capture the spread in interest rates. In reality, of course, EFC’s operations involve greater complexities than this. With the interest of keeping things reasonably simplified, we will maintain this notion.
The majority of Ellington Financial’s income is derived from interest and principal payments received on their credit portfolio, accounting for over 85% of the total income produced by their entire investment portfolio. A breakdown of EFC’s credit portfolio is displayed below.
EFC Credit Portfolio Breakdown
Source: EFC Second Quarter 2019 Earnings Conference Call Presentation
EFC’s large positions in low-grade portions of commercial and residential mortgages, consumer loans, and leveraged loans leave the company’s profitability exposed to the creditworthiness of the borrowers underlying these securitizations. Corporate profit growth rates have showed signs of deceleration coming into 2019, as we saw the global manufacturing economy struggle to maintain the momentum it saw throughout 2017 and the first half of 2018. This has naturally been coupled with a gradual rise in the spread of triple B corporate interest rates over the “risk-free” rate, from a low of around 1.16% at the beginning of 2018 to just above 1.5% today. Q4 of 2018 saw credit markets dry up, with spreads briefly topping over 2%, exposing the potential fragilities investors in low-grade credit may face during periods or economic financial stress. With yield curves signalling increased probabilities of a recession, there is mounting risk that a general slowdown in growth may feed into accelerated declines in corporate cash flows. This scenario will unlikely be observed in the near future. However, business cycles always turn, and this time will be no different. When this current cycle takes its final turn, lower cash repayments on EFC’s large portfolio of low-grade credit instruments will prove to be a large drag on the company’s profitability.
Triple B Credit Spreads
Source: Federal Reserve of St. Louis.
In addition to their vast credit portfolio, EFC derives income from its investments in Agency Residential Mortgage-Backed Securities (Agency RMBS). With 78% of their RMBS portfolio invested in 30+ year fixed rate mortgages, hedged for interest rate risk by short positions in TBA (“To Be Announced”) Mortgage Securities. These short positions in TBA securities serve to eliminate downside moves in RMBS; however, throughout the course of 2019, losses of 4.1% on these positions have essentially eliminated the 5.4% earned on the long side. Additionally, the lower mortgage rates experienced throughout 2019 have increased refinancing rates across the nation and, hence, have increased prepayment risk on EFC’s RMBS portfolio. This can be measured by a metric called Conditional Prepayment Rate or CPR, which is used to quantify the amount of the underlying mortgage balance that is paid off earlier than scheduled. The measured CPR of EFC’s long agency portfolio climbed to 12.8% in Q2 from 7.8% in Q1.
TBA Security Total Return Index
While EFC’s credit portfolio maintained returns (measured as a percent of average equity) in Q2 roughly equivalent to that of Q1 (2.74% vs. 2.78%), the profitability of their Agency RMBS portfolio took a hit of 53 basis points Quarter to Quarter. This is largely due to the losses incurred on their short TBA hedges.
EFC Earnings Breakdown
Source: Ellington Financial
Weighing Potential Risks Against Rewards
In order to accurately assess the future profitability and value of Ellington Financial, we must take into account macroeconomic trends and alternative investments with similar return characteristics. EFC trades as a stock although its inherent risk and return characteristics are best described in bond-like terms. This is due to the fact that the company’s investment is solely concentrated in fixed income instruments. The company currently trades at a dividend yield of 9.32%, which from a value perspective may seem highly attractive in comparison to similar fixed income investments. However, investors in EFC should realise that the high yield offered by the company is reflective of the economic risk exposure of the company’s outsized investments in low-grade credit.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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