Ellington Financial (NYSE:EFC) is a diversified real estate investment trust (REIT) that invests primarily in mortgages, but has exposure to other loans, securities, and financial derivatives. Recently, when researching the company’s Series A fixed to float preferred shares (NYSE:EFC.PA), I discovered that the preferred issue was callable next October with a yield to call of over 15%.
If the preferred shares were not called, they were subject to a floating rate of 3-month LIBOR plus 5.196%. With three-month LIBOR just over 4.8%, this would imply a dividend of slightly over 10% of par value and 11.5% of the current share’s price. Based on the company’s financials and the current interest rate environment, I believe the Series A preferred are a great option for income investors.
Ellington’s income statement presents a pattern seen across the REIT environment where investment in loans are involved. The company has seen an increase in interest income and interest expense in the first nine months of 2022 versus the same period last year, but the increase in income has outweighed the expense increase, leading to an increase in net interest income.
While the company saw an unrealized loss of $477 million, this is a non-cash write down involving the face value of its investments decreasing. What is rather impressive is the decrease in expenses compared to a year ago. The decrease in expenses combined with an increase in net interest income implies an increase in operating cash flow.
Ellington’s balance sheet shows a lot of activity in 2022. The company increased its loan investments and consequently its leverage. When it comes to debt, Ellington increased its repurchase agreements, (which are short term loans of assets) its secured borrowings, and issued senior notes. The company also increased its shorting of securities. While shareholder equity decreased during 2022, the company’s cash position nearly doubled which should help provide a buffer to any new volatility.
Ellington’s cash flow statement confirms what was deduced by the income statement, cash flow from operations had increased to $70 million in the first nine months of this year versus under $59 million a year ago. Ellington does not have many physical real estate assets, therefore there is an insignificant amount of capital expenditures. The other investing activities involve the principal payments from its investments, proceeds from hedging through financial derivatives, and the in and out (likely daily) of the company’s repurchase agreements.
In my opinion, dividend sustainability can be best derived from operating cash flow, which was significantly higher than the $11 million paid out in preferred dividends (see income statement). While total dividends are higher than operating cash flow, it appears that Ellington is making up the difference by issuing common shares. This presents a dilemma for common shareholders. They may retain the income from dividends, but at the expense of dilution and a consequential deduction in share price. It is important to note that Ellington recently announced another common share issuance. Preferred shareholders do not have this dilemma due to their seniority in the capital stack to common shares.
It’s important to dig deeper into what Ellington is invested in to understand the risks that it faces. The company provided a statement of investment activity (for its level 3 valuations only) showing its investments along with realized and unrealized gains and losses. The company’s largest investment is in residential mortgage loans, which also contributed to its largest unrealized loss. Upward volatility in mortgage interest rates present the biggest challenge because higher rates lead to lower valuations and less collateral for the organization to fund new financing.
It is important to note that Ellington has just under $1.5 billion in investments considered level 2 in valuation. These assets are more stable, easier to calculate the face value of, and less prone to volatility. Many of these investments consist of agency mortgage backed securities, which are higher quality assets and have the implied backing of the U.S. Treasury through the GSE program. While not a hedge, these investments provide some diversification within the asset class.
A further dive in the financials reveals a hedge being utilized by Ellington, the shorting of US Treasuries. While many people may consider this move odd due to the US government never defaulting, it is an ingenious move in my opinion. The value of US Treasuries drops as interest rates rise, therefore shorting Treasuries can be profitable in a rising rate economy and those benefits have helped offset some losses. Ellington also has a small short position on European sovereign debt. By shorting government debt, Ellington is creating a space where value may be obtained by higher interest rates.
Investors do need to be mindful of Ellington’s repurchase agreement debt, specifically that the average maturity on the entire liability is only 134 days. The short-term nature of this debt has allowed the average interest rate to go from 0.82% to 4% in nine months. While the company’s income statement has proven they have been able to manage the increase in debt servicing costs, it is still worth noting.
Ellington’s existing Series A preferred shares provide just under 8% in dividend yield, but should the company not call them next October, the dividend will float to three-month LIBOR plus 5.196%. With today’s interest rate and price of the preferred shares, that would imply a dividend yield of over 11%. Should interest rates drop, the company would likely call in the issuance, leading to a yield to call of 15%. Either way, investors should patiently await the results and enjoy the returns.
For more information on the series A preferred shares, check out the preferred share profile on QuantumOnline or the prospectus from the IPO .
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Disclosure: I/we have a beneficial long position in the shares of EFC.PA either through stock ownership, options, or other derivatives. 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.