EARN: Transforming From A 14% Yielding REIT To A CLO CEF

seekingalpha04-18

Ellington Residential Mortgage REIT has announced its decision to transform from a REIT into a closed-end fund that trades in corporate collateralized loan obligations.The transformation is seen as a ...

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Klaus Vedfelt In my latest article regarding the pending merger of the Apollo funds, AIF and AFT, with and into the BDC, MidCap Financial Investment Corp. , I discussed how those 2 CEFs will be integrated into a new asset class and that this situation represents a unique opportunity. I find it rather interesting that Apollo wants to dissolve the two CEFs, while some other fund managers are finding ways to start new ones. A new opportunity has emerged that involves a transformation from an REIT to a CEF. The oppo","collect":0,"end_time":0,"defaultTopTitle":"seekingalpha.com","property":[],"viewcount":null,"language":"en","relate_stocks":{"CEF":"Sprott Physical Gold & Silver Trust","REIT":"ALPS Active REIT ETF","EARN":"Ellington Residential Mortgage REIT","CLOI":"VanEck CLO ETF","EFC":"Ellington投资","CFA.SI":"NikkoAM-STC Asia REIT","MFIC":"MidCap Financial Investment Corp","BK4135":"资产管理与托管银行","BK4110":"抵押房地产投资信托","CCIF":"CARLYLE CREDIT INCOME FUND"},"translate_title":"赚取：由14%收益率REIT转型为CLO CEF","themeId":null,"isJumpTheme":false,"ttsUrl":null,"symbols_score_info":{"CCIF":1,"CEF":1,"CFA.SI":1,"CLOI":1,"EARN":1,"EFC":1,"MFIC":1,"REIT":1},"content_text":"Ellington Residential Mortgage REIT has announced its decision to transform from a REIT into a closed-end fund that trades in corporate collateralized loan obligations.The transformation is seen as a strategic move to take advantage of the growing CLO market and the potential benefits of CLO investments.EARN's transformation follows the trend of other fund managers finding ways to create new CEFs or transform existing ones to capitalize on the opportunities in the CLO market.   Klaus Vedfelt In my latest article regarding the pending merger of the Apollo funds, AIF and AFT, with and into the BDC, MidCap Financial Investment Corp. (MFIC), I discussed how those 2 CEFs will be integrated into a new asset class and that this situation represents a unique opportunity. I find it rather interesting that Apollo wants to dissolve the two CEFs, while some other fund managers are finding ways to start new ones. A new opportunity has emerged that involves a transformation from an REIT to a CEF. The opportunity that I am writing about today involves the April 1 announcement (no fooling!) from Ellington Residential Mortgage REIT (NYSE:EARN) regarding their decision to transform from an REIT into a closed end fund that trades in corporate CLOs. I intend to take advantage of this opportunity and will be watching closely as the plan unfolds. In case the name Ellington sounds familiar, you may have heard of Ellington Financial (EFC), also a REIT. Like EARN, the distributions from EFC are paid monthly and currently yields about 14% after reducing the dividend from $.15 to $.13 back in March. I last wrote about EFC in January, just after the completion of the acquisition of Arlington Investment. You can read more about EFC here. In January, I rated EFC a Buy, and it has gone down in price since then, at least partly due to the dividend cut, but also because REITs in general are declining in value as it appears that interest rates will be staying high for longer. This is likely one reason why EARN decided to convert from an REIT to a CEF. Comparing total returns between the two, EFC was leading in terms of total return until the past month when EARN took the lead, based on a comparison of the 1-year TR. Both have outperformed the broader Real Estate sector, as illustrated by XLRE.   Seeking Alpha CEF Market Trends There has been a moratorium on new IPOs of closed end funds for many months now. The last time a CEF went public was in November 2022 when FSCO was incepted as a publicly traded CEF. This screenshot from the  CEFConnect Fund Screener shows the list of CEFs that went public in 2021 and 2022, and none have gone public since then.   new CEFs 2021-2022 (CEFConnect) However, some clever fund managers such as Carlyle found an innovative way to create a new CEF from an existing one, like they did when they created the CLO CEF that is now Carlyle Credit Income Fund (CCIF). I discussed that transformation in the article that I titled: CCIF: Creating A Successful New CEF From A Troubled Old One And now another company has figured out a way to get around the CEF IPO suspension. EARN has announced a strategic transformation. They are converting from a mortgage REIT, or mREIT to a closed end fund, or CEF, that holds CLOs (collateralized loan obligations). Ellington Residential Mortgage REIT (the “Company”) today announced that its Board of Trustees has unanimously approved a strategic transformation of its investment strategy to focus on corporate collateralized loan obligations (“CLOs”). The Company intends to build upon its current $44 million CLO portfolio, with an emphasis on secondary CLO mezzanine debt and equity tranches. In the announcement, the CEO goes on to explain why they are making this pivot in their business model: “We are excited to pivot EARN’s investment strategy to what we believe is a highly attractive space,” said Laurence Penn, Chief Executive Officer and President. “Ellington has a longstanding and successful track record of investing in secondary CLOs, spanning more than a decade across a wide variety of market conditions, and EARN’s CLO investments to date have generated excellent returns. While the CLO market has grown significantly over the years, many parts of the market – particularly the secondary markets for CLO mezzanine debt and equity – remain highly inefficient. CCIF Offers a Successful CLO Transformation Model My initial reaction to this business decision is that it makes a lot of sense, and is, in fact, very similar to what CCIF did. The performance of CCIF since it completed its transition to a CLO CEF has been very good, even with the broader market correction over the past few weeks. I rated CCIF a Strong Buy back in December, and it has a total return of just over 7% since then.   Seeking Alpha However, much of that return is in the form of monthly distributions, which the fund just increased by 5% on March 1. The distribution history since CCIF switched over from mortgage REITs to CLOs has been very rewarding for income investors. The distribution was nearly doubled in September 2023 after the CCIF conversion was completed and the first CLO distribution was declared.   CEFConnect While most of the better-known CLO equity funds such as OXLC and ECC have mostly traded at a premium over the past few years, CCIF trades near par today, closing the discount that it traded for previously when it was known as VCIF. This 3-year chart shows how the discount essentially disappeared in summer of 2023 when the CCIF conversion was completed. Unfortunately, previous holders of VCIF lost a lot of capital (based on when they bought) as the NAV and then the price dropped substantially due to the conversion.   CEFConnect Mixed REIT Ratings The existing REIT that is EARN today gets mixed reviews from both Wall Street analysts with an average Hold rating, and SA Analysts who rate the mREIT a Buy with its 14% dividend yield based on the $.08 monthly dividend that the company intends to continue paying. The most recent dividend was declared on April 9 with an ex-div date of April 29 but payable May 28.   Seeking Alpha  Schwab Existing EARN investors may wish to continue holding their shares and collect the 14% yield while the conversion is taking place. As CEO Penn explains in the press release, the transformation will take some time, but the costs are manageable and should greatly enhance their ability to grow book value and increase shareholder returns in the future. We expect that EARN’s differentiated approach to CLO investing will capitalize on these inefficiencies and drive earnings growth, all while utilizing lower leverage. We believe that this strategic transformation will greatly enhance our ability to grow book value per share over time and unlock additional value for our shareholders. Furthermore, thanks to the high liquidity of our Agency MBS pool portfolio, the conversion to a closed end fund/RIC, including the transitioning of the investment portfolio, should entail only modest costs. CLO Strategic Transformation As part of the transformation, the company has revoked its REIT status for 2024 and has filed all the necessary paperwork and requested approvals to convert to a closed end fund to be treated as a RIC later this year. In the Summary slide from the EARN CLO Strategic Transformation presentation, the reasons why the CLO conversion was suggested and approved by the Board are outlined.   EARN presentation In the meantime (according to the presentation materials) while the company is in the process of applying for the CEF approvals, it will operate as a C-Corp and plans to take advantage of significant existing NOLS (net operating loss carryforwards) to offset the majority of its tax burden.   EARN presentation The company expects to change its name to Ellington Credit Company but will keep the ticker symbol EARN. Well, that is nice since ECC is already taken by Eagle Point Credit Company, which also happens to be a CLO CEF. Therefore, if someone did a Google search on ECC, they just might see Ellington Credit Company show up in their search results. These guys have thought of everything! There are of course several anticipated benefits to shareholders associated with the CLO transformation, and rather than attempt to summarize them for you, I will just include another slide from the presentation.   EARN presentation The CLO Market Opportunity Now I must admit that this seems like rather clever timing with the much-anticipated interest rate cuts no longer on the near-term horizon. If rates stay high for longer, that will be to the detriment of mortgage-backed securities and the real estate sector in general, and to the benefit of CLOs. Cost of capital, including leverage, is more manageable with CLOs as well, at least according to the company materials. And the CLO asset class is performing well in 2024 with a positive outlook for the rest of the year and into 2025. The CLO market is growing and increasing in liquidity and scalability.   EARN presentation According to VanEck, the outlook for the CLO market in 2024 is quite optimistic after a very good year in 2023. They believe that CLOs will continue to rally this year, too. CLOs generated strong total returns across the capital stack in 2023. However, CLOs underperformed bank loans as well as fixed-rate high yield bonds during the year as Treasury yields declined, but outperformed investment grade corporates.   VanEck About Ellington Management Ellington Management Group was founded in 1994 and now has 3 global offices with about $10.3B in AUM worldwide as of 12/31/23. Through affiliated companies including Ellington Financial Management LLC, they manage both EFC and EARN as well as multi-investor hedge funds, separately managed accounts, and private capital. Compared to Carlyle Group with $426 billion in AUM, Ellington is small potatoes. However, they have 29 average years of experience with their senior portfolio managers and specialized expertise in structured credit trading and analysis. The company believes that this gives them an edge in the CLO investment world. Ellington believes that they have a differentiated CLO strategy when it comes to investing in that asset class, as explained on this slide from the presentation.   EARN According to their investor presentation, the company has developed proprietary analysis systems and models for evaluating CLO investment opportunities and risks.   EARN presentation Whether or not these systems and models are better than what other competing organizations have available to them remains to be seen, but the company appears to be confident in their ability to analyze the CLO marketplace. Comparison to Other CLO Funds There have been several new funds besides the ones I have already mentioned: OXLC, ECC, and CCIF, that offer investors a strong income and total return from CLO investments, both in equity and debt tranches. Some other CEFs that invest in CLO holdings include EIC, OCCI, XFLT, ARDC, with the latter two holding both CLOs and senior loans. Some relatively new ETFs that I am aware of that hold CLOs include VanEck CLO ETF (CLOI), CLOZ, JAAA and JBBB. The yields and performance vary for each based on the CLO tranches held, size of the fund, history, etc. Generally, the riskier tranches, which are the equity tranches of CLOs, offer the highest yields but also entail the most risk. I feel that CCIF offers the best comparison to what an EARN CEF might become, given its recent history and transformation from a fund that held mostly mortgage-backed securities to one that now holds CLOs, both the equity and debt tranches. It also yields about 15% (compared to EARN at 14%) based on the monthly dividend of $.105 per share. According to the March 1 CCIF earnings call the CLO market is off to a great start in 2024 based on comments from CEO, Lauren Basmadjian: CLO issuance had a record January as liabilities tightened significantly and the arbitrage for new CLOs increased to the highest that it’s been in 10 months. Loan issuance has been robust, starting with a repricing wave, then extensions of existing capital structures, and finally, true net new issuance in the form of add-ons for existing borrowers to fund token M&A, dividend deals and a number of private credit loans pivoting to the liquid market so that they could cut their interest expense. Also, my perspective that is shared by Carlyle is that interest rates are likely to stay high for longer. That will likely benefit the equity distributions from CLOs as she further explained: Carlyle’s house view is, though we are likely to see rate cuts this year, we will be operating in a higher rate environment for some time. We think this is a positive for CLO equity distributions as they benefit from higher base rates as long as defaults don’t pick up significantly. Conclusion The CLO market is hot, the REIT market is not. The management team at Ellington are either making a very intelligent strategic decision to convert EARN from an REIT to a CEF, or they are making a foolish mistake at a bad time. While loan defaults are starting to creep up, the US economy remains strong and credit spreads still offer very good returns from CLOs. The risk is that we are approaching a market top, and a reversal could have a dramatic impact on the timing of the fund conversion. But loan issuance relative to CLOs remains low, providing a level of support as explained on this slide.   EARN presentation For those who already hold shares of EARN, I would suggest continuing to hold, and you possibly may want to add some shares while the market is undergoing a correction, and the price has dropped back below $7. For those who are less interested in holding a CLO CEF for whatever reason and prefer to hold shares of an REIT may want to sell their shares when the price rises back above $7 and buy EFC instead. I have some reservations about the relatively small size of the CLO holdings that are currently held by EARN (about $44 million as of 3/28/24) and do not know enough about their expertise in CLO trading and analysis beyond what I have read in their investor materials. This slide summarizes their CLO expertise as an REIT since 2012.   EARN presentation My personal belief is that both EFC and EARN have been well managed REITs that offer high-yield distributions and despite a difficult environment for REITs they have both performed relatively well over the last year at least. That gives me some confidence in the ability of Ellington Management to successfully pull off this transformation to a CEF.  The company has also stated that they remain committed to paying out the same $.08 monthly dividend during the transition period. That language should assuage current investors who fear that their investment in the REIT may lose value. I am encouraged by the Board’s decision and would encourage risk-tolerant investors to Buy shares of EARN now at a price below $7 given the information that I have presented. I am interested in hearing others’ thoughts.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.1","shortVersion":"4.29.1","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2428533328"}