Market Overview

Ellington Residential Mortgage REIT Reports Third Quarter 2017 Results

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Ellington Residential Mortgage REIT (NYSE:EARN) today reported financial
results for the quarter ended September 30, 2017.

Highlights

  • Net income of $6.3 million, or $0.48 per share.
  • Core Earnings1 of $5.0 million, or $0.38 per share, and
    Adjusted Core Earnings1 of $5.6 million, or $0.43 per share.
  • Book value of $14.76 per share as of September 30, 2017, after giving
    effect to a third quarter dividend of $0.40 per share.
  • Net interest margin of 1.30%, and adjusted net interest margin2
    of 1.45%.
  • Weighted average constant prepayment rate for the fixed-rate Agency
    specified pool portfolio of 9.6%.
  • Dividend yield of 11.9% based on November 1, 2017 closing stock price
    of $13.41.
  • Debt-to-equity ratio of 8.3:1 as of September 30, 2017.

Third Quarter 2017 Results

"In the third quarter, Ellington Residential had net income of $0.48 per
share and Adjusted Core Earnings of $0.43 per share," said Laurence
Penn, Chief Executive Officer and President. "Our dividend of $0.40 was
more than covered by our net income, and in addition to achieving
outstanding returns on our investment portfolio, we also benefited from
a lower expense ratio following the equity raise last quarter that
increased our capital base. We generated an annualized economic return
for the quarter of 12.8%, and our book value per share increased quarter
over quarter, even after payment of the dividend.

"The quarter's results were driven by the strong performance of Agency
RMBS, which finally participated in the spread tightening that most
other fixed-income classes had already experienced this year. In
September, after the Federal Reserve announced the initiation of its
tapering program, the mortgage basis tightened significantly, suggesting
that many investors had been waiting for policy clarity before adding
Agency RMBS exposure. We were well positioned for this spread
tightening, as we had reduced our TBA short position coming into the
quarter, and we had just deployed into Agency RMBS the vast majority of
the capital we had raised in our well-timed second quarter equity raise.
We believe that we will be able to take advantage of many more such
opportunities as the Federal Reserve continues to reduce its footprint
in the Agency RMBS market.

"Our portfolio also benefited from the outperformance of specified pools
versus TBAs, as we continued to concentrate our long investments in
specified pools. Additionally, our small portfolio of non-Agency RMBS
again performed very well this quarter, contributing nicely to
performance.

"The yield curve continued to flatten during the third quarter, putting
downward pressure on our adjusted net interest margin and Adjusted Core
Earnings. However, our portfolio management style includes active
trading, hedging along the entire yield curve, and hedging using
significant TBA short positions. As a result, and as demonstrated by our
strong results this past quarter, we believe that our success is not
dependent on the shape of the yield curve or the absolute level of
interest rates.

"Our larger equity base resulting from the second quarter equity raise
also caused our annualized expense ratio to decline from 3.6% to 3.0%
quarter over quarter. During the third quarter, we raised $13.9 million
of additional equity via our at-the-market (ATM) program. We believe the
ATM program provides an attractive, low-cost path to growth, and we plan
to continue to utilize it as investment opportunities and market
conditions warrant. Based on our third-quarter ATM issuance alone, we
project an additional 0.11% decline in our annualized expense ratio."

 
1 Core Earnings and Adjusted Core Earnings are non-GAAP financial
measures. Adjusted Core Earnings represents Core Earnings excluding
the effect of the Catch-up Premium Amortization Adjustment on
interest income. See "Reconciliation of Core Earnings to Net Income"
below for an explanation regarding the calculation of Core Earnings,
Adjusted Core Earnings, and the Catch-up Premium Amortization
Adjustment.
2 Adjusted net interest margin represents net interest margin
excluding the effect of the Catch-up Premium Amortization Adjustment
on interest income.
 

Market Overview

  • In October, the Federal Reserve initiated its balance sheet
    normalization program, and began tapering asset purchases of both U.S.
    Treasury securities and Agency RMBS. At the November Federal Open
    Market Committee, or "FOMC," meeting, the Federal Reserve maintained
    the target range for the federal funds rate at 1.00%–1.25%.
  • For the third consecutive quarter, the yield curve flattened. The
    2-year U.S. Treasury yield rose 10 basis points to end the quarter at
    1.48%, while the 10-year U.S. Treasury yield increased only 3 basis
    points to 2.33%.
  • Despite the rise in U.S. Treasury yields, mortgage rates declined over
    the course of the third quarter, with the Freddie Mac survey 30-year
    mortgage rate falling 5 basis points to end the quarter at 3.83%.
  • Overall Agency RMBS prepayment rates declined slightly during the
    quarter. The Mortgage Bankers Association's Refinance Index, which
    measures refinancing application volumes, increased 2.0% quarter over
    quarter but remains well below the multi-year high reached in mid-2016.

Volatility remained at historic lows during the third quarter. The
Merrill Lynch Option Volatility Estimate Index, or MOVE Index, declined
to an all-time low, while the Chicago Board Options Exchange Volatility
Index, known as the VIX, dropped to its lowest level in 23 years. U.S.
Treasury yields were again range-bound, with the 10-year U.S. Treasury
trading within a 35-basis point range during the quarter.

During the quarter, yield spreads across most credit products, including
non-Agency RMBS, remained at the tightest points of their trailing
two-year ranges. Corporate credit spreads fluctuated intra-quarter but
finished the quarter tighter. As in prior quarters, demand remained
strong for floating-rate debt instruments, including CLOs and leveraged
loans. Finally, damage from recent hurricanes and ongoing negative
headlines in retail led to heightened volatility in the CMBS market
during the quarter.

Also during the third quarter, Agency RMBS finally participated in the
spread tightening that other fixed-income asset classes had already
benefited from this year. After the Federal Reserve announced at its
September meeting the initiation of its tapering program, the Agency
mortgage basis tightened significantly, suggesting that many investors
had been waiting for policy clarity before adding Agency RMBS exposure.
As measured by the Bloomberg Barclays U.S. MBS Agency Fixed Rate Index,
Agency RMBS generated an excess return over the Bloomberg Barclays U.S.
Treasury Index of 48 basis points for the quarter.

Mortgage REIT buying of Agency RMBS was also widespread following a
number of equity raises, suggesting that private capital has been
willing and able, at least so far, to replace the Federal Reserve's
footprint in the market. Year-to-date through October 31, 2017,
residential mortgage REITs have raised approximately $8.1 billion of
capital, representing over $40 billion of Agency RMBS buying power. At
the same time, low interest rate volatility and a muted prepayment
environment have provided a significant tailwind to the sector.

Financial Results

Holdings

As of September 30, 2017, our mortgage-backed securities portfolio
consisted of $1.615 billion of fixed-rate Agency "specified pools,"
$27.1 million of Agency RMBS backed by adjustable rate mortgages, or
"Agency ARMs," $68.1 million of Agency reverse mortgage pools, $12.1
million of Agency interest only securities, or "Agency IOs," and $20.6
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 increased by 5.4% to $1.743 billion as of
September 30, 2017, as compared to $1.653 billion as of June 30, 2017.
The increase in the size of our portfolio primarily reflects the
investment, on a leveraged basis, of the proceeds received from sales of
common shares under our ATM program, though overall our debt-to-equity
ratio, adjusted for unsettled purchases and sales, decreased to 8.3:1 as
of September 30, 2017 from 8.5:1 as of June 30, 2017. Our debt-to-equity
ratio may fluctuate period over period based on portfolio management
decisions, market conditions, and the timing of security purchase and
sale transactions. The majority of the ATM proceeds were invested in
fixed-rate specified pools. In addition, separate from the net short TBA
portfolio that we hold for hedging purposes, we decreased our long TBA
positions that we hold for investment purposes to $105.8 million in
notional amount at September 30, 2017, as compared to $121.3 million at
June 30, 2017.

With the tightening in Agency RMBS yield spreads, our portfolio
performed well in the third quarter. We also benefited from the
outperformance of specified pools versus TBAs, as we continued to
concentrate our long investments in specified pools, and to hold net
short positions in TBAs as a significant component of our interest rate
hedging strategy. Slightly lower roll costs in higher coupon TBAs and
increased investor demand for specified pools were key drivers of the
outperformance. Average pay-ups on our specified pools were unchanged at
0.71% as of September 30, 2017, as compared to June 30, 2017. Pay-ups
are price premiums for specified pools relative to their TBA
counterparts.

Our non-Agency RMBS performed well in the third quarter, driven by net
realized and unrealized gains and interest income. As the case has been
for some time, the fundamentals underlying non-Agency RMBS, led by a
stable housing market, continue to be strong. During the quarter we sold
assets at net gains while also adding to the portfolio. As a result, our
total investment in non-Agency RMBS remained unchanged at $20.6 million
as of September 30, 2017 as compared to June 30, 2017. To the extent
that more attractive entry points develop in non-Agency RMBS, we may
further increase our capital allocation to this sector.

Earnings and Net Interest Margin

We had net income of $6.3 million, or $0.48 per share, for the quarter
ended September 30, 2017, as compared to $1.6 million, or $0.15 per
share, for the quarter ended June 30, 2017. For the quarter ended
September 30, 2017, Core Earnings was $5.0 million, or $0.38 per share,
as compared to $4.8 million, or $0.45 per share, for the quarter ended
June 30, 2017. Adjusted Core Earnings for the quarter ended
September 30, 2017 was $5.6 million, or $0.43 per share, as compared to
$5.1 million, or $0.47 per share, for the quarter ended June 30, 2017.
Lower per share Core Earnings and Adjusted Core Earnings in the current
quarter was mainly due to the quarter over quarter decline in net
interest margin, largely related to an increase in repo borrowing rates
in the third quarter. Core Earnings and Adjusted Core Earnings are
non-GAAP financial measures. See "Reconciliation of Core Earnings to Net
Income" below for an explanation regarding the calculation of Core
Earnings, Adjusted Core Earnings, and the Catch-up Premium Amortization
Adjustment.

For the quarter ended September 30, 2017, the weighted average yield of
our portfolio of Agency and non-Agency RMBS was 2.86%, while our average
cost of funds including interest rate swaps and U.S. Treasury securities
was 1.56%, resulting in a net interest margin for the quarter of 1.30%.
In comparison, for the quarter ended June 30, 2017, the weighted average
yield of our Agency and non-Agency RMBS was 2.94%, while our average
cost of funds including interest rate swaps and U.S. Treasury securities
was 1.38%, resulting in a net interest margin of 1.56%. For the third
and second quarters, excluding the impact of the Catch-up Premium
Amortization Adjustment, the weighted average yield of our portfolio
remained unchanged at 3.01% and our adjusted net interest margin was
1.45% and 1.63%, 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 1.56% from 1.38%. This quarter-over-quarter
increase resulted primarily from an increase in our cost of repo, which
increased as LIBOR rose. Our average cost of repo increased 22 basis
points quarter over quarter to 1.31%, while the cost related to our
interest rate swaps and U.S. Treasury securities decreased by 2 and 3
basis points from prior quarter, respectively. The relative make up of
our interest rate hedging portfolio can change materially from quarter
to quarter.

For the quarter ended September 30, 2017, we had total net realized and
unrealized gains of $3.8 million, or $0.29 per share, on our aggregate
Agency RMBS portfolio. Agency RMBS spread tightening during the period
led to the net gains. For the same period we had total net realized and
unrealized gains of $0.7 million, or $0.06 per share, on our non-Agency
RMBS portfolio as underlying fundamentals remained strong.

During the quarter we continued to hedge interest rate risk, primarily
through the use of interest rate swaps and short positions in TBAs, and
to a lesser extent, short positions in U.S. Treasury securities. For the
quarter, we had total net realized and unrealized losses of $(3.9)
million, or $(0.29) per share, on our interest rate hedging portfolio.
In our hedging portfolio, the relative proportion (based on 10-year
equivalents3) of TBA short positions increased slightly
quarter over quarter relative to interest rate swaps.

After giving effect to a third quarter dividend of $0.40 per share, our
book value per share increased to $14.76 as of September 30, 2017, from
$14.71 as of June 30, 2017, and we had an economic return of 3.1% 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.

 
3 "10-year equivalents" for a group of positions represent the amount
of 10-year U.S. Treasury securities that would experience a similar
change in market value under a standard parallel move in interest
rates.
 

Securities Portfolio

The following table summarizes our portfolio of securities as of
September 30, 2017 and June 30, 2017:

   
September 30, 2017 June 30, 2017
(In thousands)

Current
Principal

    Fair Value  

Average
Price(1)

    Cost  

Average
Cost(1)

 

Current
Principal

    Fair Value  

Average
Price(1)

    Cost  

Average
Cost(1)

Agency RMBS(2)    
15-year fixed-rate mortgages $ 177,485 $ 185,268 $ 104.39 $ 185,456 $ 104.49 $ 174,413 $
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