Ellington Residential Mortgage REIT Reports Second Quarter 2018 Results
OLD GREENWICH, Conn.--(BUSINESS WIRE)--Aug 2, 2018--Ellington Residential Mortgage REIT (NYSE: EARN) today reported financial results for the quarter ended June 30, 2018.
HighlightsNet income of $1.8 million, or $0.14 per share. Core Earnings 1 of $5.1 million, or $0.40 per share, and Adjusted Core Earnings 1 of $4.6 million, or $0.36 per share. Book value of $13.70 per share as of June 30, 2018, after giving effect to a second quarter dividend of $0.37 per share. Net interest margin of 1.28%, and adjusted net interest margin 2 of 1.17%. Weighted average constant prepayment rate for the fixed-rate Agency specified pool portfolio of 8.2%. Dividend yield of 13.4% based on the August 1, 2018 closing stock price of $11.07. Debt-to-equity ratio of 8.8:1 as of June 30, 2018; adjusted for unsettled purchases and sales, the debt-to-equity ratio was 8.6:1. Net mortgage assets-to-equity ratio of 7.4:1 3 as of June 30, 2018. Repurchased 115,800 shares during the quarter, or approximately 1% of our outstanding shares as of the beginning of the quarter, at an average price of $11.01 per share.
Second Quarter 2018 Results
“In the second quarter, Ellington Residential had net income of $0.14 per share and Adjusted Core Earnings of $0.36 per share,” said Laurence Penn, Chief Executive Officer and President. “During the quarter, higher interest rates caused Agency RMBS asset prices to decline modestly, but EARN’s book value was stable as solid net carry on our portfolio and gains on our interest rate hedges more than offset these price declines. Share repurchases provided a tailwind, and altogether our economic return for the quarter was 1.2%, or 5.0% annualized.
“The bear market flattening of the yield curve over the past 18 months has put downward pressure on our net interest margin, but we continue to take advantage of the asset opportunities and higher yields by turning over meaningful portions of our portfolio, in order to recharge our net interest margin and boost core earnings. We expect this activity to continue throughout the third quarter.
“Despite the ongoing technical drag from Fed tapering, we believe that Agency RMBS offer attractive relative value today, with favorable prepayment fundamentals and yield spreads that remain near their two-year widest levels, in contrast to many credit sectors where spreads remain near their two-year tightest levels. As a result, after having covered a significant portion of our TBA short position in March in response to the market selloff, we continue to keep our net mortgage exposure relatively high.
“Looking forward, as quantitative easing around the globe continues to give way to quantitative tightening, the market will continue to lose an important stabilizing force. The market is pricing in continued record low volatility, but if volatility returns, we would expect more investment opportunities and chances to differentiate ourselves. We believe that our hedging strategy and our highly liquid portfolio will allow us to take advantage of such opportunities while also preserving book value.”
Market OverviewIn June, the Federal Reserve raised the target range for the federal funds rate by 0.25%, to 1.75%–2.00%, its seventh rate increase since December 1, 2015 and its second rate increase so far in 2018. LIBOR rates, which drive many of our financing costs, increased in sympathy, with one-month LIBOR increasing 21 basis points to end the second quarter at 2.09%. In April and July, the Federal Reserve continued to increase the amount of the tapering of its reinvestments in line with the schedule it had laid out in September 2017. The tapering of Agency RMBS purchases increased to $12 billion per month in April and to $16 billion per month in July. The tapering of U.S. Treasury purchases increased to $18 billion per month in April and to $24 billion per month in July. The yield curve flattened for the sixth consecutive quarter: the 2-year U.S. Treasury yield rose 26 basis points to end the second quarter at 2.53%, while the 10-year U.S. Treasury yield rose 12 basis points to 2.86%. The spread between the 2-year and 10-year tightened to just 33 basis points, as compared to 47 basis points at the end of the first quarter. Mortgage rates increased in the second quarter, with the Freddie Mac survey 30-year mortgage rate rising 11 basis points to end the quarter at 4.55%. Overall Agency RMBS prepayment rates continued to be muted during the quarter. The Mortgage Bankers Association’s Refinance Index, which measures refinancing application volumes, fell 11.9% quarter over quarter, dropping intra-quarter to its lowest seasonally-adjusted level in more than 17 years.
The second quarter of 2018 saw the extreme equity volatility of the first quarter subside, but interest rate choppiness and yield curve flattening continue. During the first part of the quarter, interest rates continued their recent upward trend, with the 10-year U.S. Treasury yield rising 37 basis points to an almost seven-year high of 3.11% on May 17 th. Over the next two weeks, this trend reversed, as investors reacted to a possible trade war and political uncertainty in Italy; by May 29 th, the 10-year U.S. Treasury had rallied nearly back to where it started the quarter. The flight to quality was short-lived, however, and the 10-year U.S. Treasury yield finished the quarter 12 basis points higher overall. The yield curve has lately been the flattest it has been since 2007, when it actually inverted during the early part of the year.
Performance was mixed for the quarter across the various credit-sensitive sectors. Investment grade and high yield corporate credit spreads tightened during April but then widened in May and June, and finished the quarter approximately flat. Meanwhile, CMBS credit spreads generally tightened during the quarter (with especially strong demand for higher-yielding, non-investment grade CMBS securities), and the legacy non-Agency RMBS market continued to be well supported. The continued increase in LIBOR boosted coupons of floating-rate debt instruments, benefiting CLOs, leveraged loans, and other structured credit products.
Despite higher rates and the continued increase of Fed tapering, Agency RMBS spreads generally held firm over the quarter, continuing to benefit from a muted prepayment environment. As measured by the Bloomberg Barclays U.S. MBS Agency Fixed Rate Index, Agency RMBS generated a total return of 24 basis points for the quarter, and an excess return (on a duration-adjusted basis) over the Bloomberg Barclays U.S. Treasury Index of 15 basis points.
As of June 30, 2018, our mortgage-backed securities portfolio consisted of $1.451 billion of fixed-rate Agency “specified pools,” $20.7 million of Agency RMBS backed by adjustable rate mortgages, or “Agency ARMs,” $76.8 million of Agency reverse mortgage pools, $19.1 million of Agency interest only securities, or “Agency IOs,” and $12.0 million of non-Agency RMBS. Specified pools are fixed-rate Agency pools consisting of mortgages with special characteristics, such as mortgages with low loan balances, mortgages backed by investor properties, mortgages originated through the government-sponsored “Making Homes Affordable” refinancing programs, and mortgages with various other characteristics.
Our overall RMBS portfolio decreased by 3.1% to $1.580 billion as of June 30, 2018, as compared to $1.631 billion as of March 31, 2018. Even though our portfolio was slightly smaller by quarter end, our equity base was also slightly smaller and our overall debt-to-equity ratio, adjusted for unsettled purchases and sales, was unchanged at 8.6:1 as of June 30, 2018, as compared to March 31, 2018. Our debt-to-equity ratio may fluctuate period over period based on portfolio management decisions, market conditions, capital markets activities, and the timing of security purchase and sale transactions.
With Agency RMBS yield spreads remaining near their two-year widest levels in the second quarter, we continued to maintain a smaller short TBA position that we use for hedging purposes, as well as a larger long TBA portfolio held for investment purposes, compared to how we were positioned in previous years. As of June 30, 2018, we had short TBAs of $448.6 million, as compared to $386.2 million as of March 31, 2018. Also as of June 30, 2018, we had $153.7 million of long TBAs held for investment purposes, as compared to $142.9 million as of March 31, 2018. As a result, our net mortgage assets-to-equity ratio decreased slightly quarter over quarter to 7.4:1 from 7.8:1, but was still meaningfully higher than as of December 31, 2017, when this ratio was 5.7:1, as well as compared to the quarter-end average over the past three years ended December 31, 2017 of 5.7:1. TBAs are forward-settling Agency RMBS where the mortgage pass-through certificates to be delivered are “To-Be-Announced.”
With Agency RMBS prices declining again during the second quarter, our portfolio had significant realized and unrealized losses. While these losses were partially offset by significant gains on our interest rate swaps, futures, and TBA short positions, strong TBA dollar rolls and muted prepayments caused TBAs to outperform specified pools, which further dampened our results. Short positions in TBAs continue to represent a significant portion of our interest rate hedging portfolio.
Average pay-ups on our specified pools were essentially unchanged at 0.58% as of June 30, 2018, as compared to 0.59% as of March 31, 2018. Pay-ups are price premiums for specified pools relative to their TBA counterparts. Additionally, our GNMA portfolio benefited from a significant drop in GNMA prepayment speeds during the quarter, which reflected the impact of a new law inhibiting “churning” of VA loans, as well as certain disciplinary actions taken by GNMA against several originators whose loans have exhibited abnormally high prepayment speeds.
Our non-Agency RMBS performed well during the quarter, driven by strong net interest income, which was slightly offset by net realized and unrealized losses as prices declined marginally in the sector during the quarter. Fundamentals underlying non-Agency RMBS continue to remain strong, led by a stable housing market. Our total investment in non-Agency RMBS was relatively unchanged at $12.0 million as of June 30, 2018, as compared to $12.4 million as of March 31, 2018. To the extent that more attractive entry points develop in non-Agency RMBS, we may increase our capital allocation to this sector.
Earnings and Net Interest Margin
We had net income of $1.8 million, or $0.14 per share, for the quarter ended June 30, 2018, as compared to a net loss of $(4.0) million, or $(0.30) per share, for the quarter ended March 31, 2018. The net income for the quarter was primarily driven by strong net interest income on our Agency RMBS investments and net gains from our interest rate hedges, partially offset by realized and unrealized losses on our Agency RMBS investments. For the quarter ended June 30, 2018, Core Earnings was $5.1 million, or $0.40 per share, as compared to $4.3 million, or $0.32 per share, for the quarter ended March 31, 2018. Adjusted Core Earnings for the quarter ended June 30, 2018 was $4.6 million, or $0.36 per share, as compared to $4.4 million, or $0.34 per share, for the quarter ended March 31, 2018. The higher Core Earnings and Adjusted Core Earnings in the current quarter resulted from the increase in our quarter-over-quarter adjusted net interest margin, reflecting the higher asset yields following portfolio turnover, partially offset by increases in repo borrowing rates. Core Earnings and Adjusted Core Earnings are non-GAAP financial measures. See “Reconciliation of Core Earnings to Net Income (Loss)” below for an explanation regarding the calculation of Core Earnings, Adjusted Core Earnings, and the Catch-up Premium Amortization Adjustment.
For the quarter ended June 30, 2018, the weighted average yield of our portfolio of Agency and non-Agency RMBS was 3.26%, while our average cost of funds, including interest rate swaps and U.S. Treasury securities, was 1.98%, resulting in a net interest margin for the quarter of 1.28%. By comparison, for the quarter ended March 31, 2018, the weighted average yield of our Agency and non-Agency RMBS was 2.99%, while our average cost of funds, including interest rate swaps and U.S. Treasury securities, was 1.93%, resulting in a net interest margin of 1.06%. Excluding the impact of the Catch-up Premium Amortization Adjustment, the weighted average yield of our portfolio increased to 3.15% for the second quarter as compared to 3.02% for the first quarter, and our adjusted net interest margin was 1.17% and 1.09%, respectively.
On a quarter-over-quarter basis, our cost of funds, including the cost of repo, interest rate swaps, and short positions in U.S. Treasury securities, increased to 1.98% from 1.93%. This quarter-over-quarter increase resulted mainly from an increase in our repo borrowing rates, which increased as LIBOR rose. Our average repo borrowing rate increased 33 basis points quarter over quarter to 1.96%. This increase was partially offset by lower costs related to our short positions in U.S. Treasury securities and interest rate swaps, which decreased 28 basis points from the prior quarter.
For the quarter ended June 30, 2018, prices on our Agency RMBS portfolio declined, and we had total net realized and unrealized losses of $(10.1) million, or $(0.79) per share. Our Agency RMBS portfolio turnover was 17% for the quarter, which was modestly higher than the prior quarter. In addition, we had total net realized and unrealized losses of $(0.1) million, or $(0.01) per share, on our non-Agency RMBS portfolio as prices declined slightly during the quarter.
During the quarter we continued to hedge interest rate risk, primarily through the use of interest rate swaps, short positions in TBAs, U.S. Treasury securities, and futures. For the quarter, we had total net realized and unrealized gains of $7.0 million, or $0.55 per share, on our interest rate hedging portfolio, as interest rates increased. In our hedging portfolio, the relative proportion (based on 10-year equivalents 4 ) of short positions in TBAs increased slightly quarter over quarter relative to our other interest rate hedges, as we marginally decreased our exposure to Agency RMBS. The relative makeup of our interest rate hedging portfolio can change materially from quarter to quarter.
After giving effect to a second quarter dividend of $0.37 per share, our book value per share decreased to $13.70 as of June 30, 2018, from $13.90 as of March 31, 2018, and we had an economic return of 1.2% for the quarter. Economic return is computed by adding back dividends declared to ending book value per share, and comparing that amount to book value per share as of the beginning of the quarter.
The following table summarizes our portfolio of securities as of June 30, 2018 and March 31, 2018:
Our weighted average holdings of RMBS based on amortized cost was $1.689 billion and $1.728 billion for the three-month periods ended June 30, 2018 and March 31, 2018, respectively.
Financial Derivatives Portfolio
The following table summarizes fair value of our financial derivatives as of June 30, 2018 and March 31, 2018:
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