AGNC - Ellington Residential Mortgage REIT: This 15% Yielding Mortgage Trust Could Outperform (Upgrade)

2023-09-26 07:30:54 ET

Summary

• Ellington Residential Mortgage REIT's stock has fallen to new lows, presenting an opportunity to increase positions by 30%.
• The trust is selling at a 21% discount to book value, indicating a potential dividend cut is already priced in.
• The end of the rate-hiking cycle is near, which could lead to interest rate cuts and improved earnings for the trust.

Ellington Residential Mortgage REIT Inc. ( EARN ) is a well-managed mortgage real estate investment trust that focuses on the residential mortgage security market.

The trust suffered mightily from a rise in capital costs in recent quarters, which has led to lower earnings and a declining book value. With that being said, the end of the rate-hiking cycle appears near, in my view, as inflation is easing, which could lead to interest rate cuts moving forward.

Ellington Residential Mortgage REIT’s stock has recently fallen to new 52-week lows, which I used to increase my position in the mortgage REIT by 30%.

The trust is selling at an exaggerated discount to book value of 21%, and the risk-reward ratio has improved lately.

My Rating History

I purchased Ellington Residential Mortgage REIT after the mortgage trust slashed its dividend pay-out by 20% in 2022 due to insufficient earnings in a rising-rate environment.

I considered Ellington Residential Mortgage REIT to be an attractive investment for passive income investors at the start of the year in my article Ellington Residential: Wait For A Drop Before Buying This 14% Yield . Taking into account that the trust’s stock is now trading at a much wider book value discount, my stock classification changes to (speculative) buy.

Impact Of Rising Interest Rates

Rising interest rates are rarely good news for companies that deploy a lot of leverage, including mortgage REITs. Mortgage REITs do well when capital is cheap so that they can buy high-yielding mortgage securities and make money on the spread between asset yield and borrowing costs.

Since the central bank has aggressively pushed rates higher in 2022 in order to compensate for higher consumer prices, mortgage REITs have seen steep valuation haircuts. These valuation declines reflect unfavorable margin developments as well as more uncertainty surrounding a mortgage trust’s book value.

In the second quarter, Ellington Residential Mortgage REIT’s interest expenses exceeded its interest income by $1.6 million, reflecting how vulnerable mortgage trusts are to changes in short-term interest rates.

Ellington Residential Mortgage REIT is primarily focused on acquiring, investing in, and managing residential mortgage and real estate-related assets, particularly those that are backed by the full faith and credit of the U.S. Government.

At the end of the second quarter, Ellington Residential Mortgage REIT still had an aggressive focus on 30-year fixed-rate mortgages, which accounted for 91% of the trust’s investments. In addition to the Agency portion of the portfolio, Ellington Residential Mortgage REIT owned $24.4 million of non-Agency investments.

Dividend Cut Is Likely

Right now, Ellington Residential Mortgage REIT does not cover its cumulative dividend of $0.24 per share per quarter (paid monthly in installments of $0.08 per share). The mortgage REIT had a dividend pay-out ratio of 108% in the last twelve months, and in the second quarter, the pay-out ratio has gotten much worse: it rose to an unsustainable 141%.

As a consequence, a dividend cut in the short term is probable, but I think that a dividend cut is already priced into Ellington Residential Mortgage REIT’s valuation at this point, as I will explain next.

21% Discount To Book Value

Ellington Residential Mortgage REIT is trading at a 21% discount to book value, which at the end of the second quarter was reported to be $8.12 per share. The large discount to book value, especially compared to other mortgage trusts that trade at or near book value, suggests that the market anticipates a dividend cut.

Since 2Q-22, Ellington Residential Mortgage REIT’s book value has dropped 11%. For comparison purposes, Annaly Capital Management Inc. ( NLY ) reported a 12% YoY drop in book value. Major mortgage trusts like Annaly Capital Management or AGNC Investment Corp. ( AGNC ) now trade close to book value.

Why Ellington Residential Mortgage REIT Might See A Lower Or Higher Multiple

Ellington Residential Mortgage REIT depends, as a leveraged mortgage trust, on the central bank and its view on inflation and consumer prices. An ongoing increase in short-term interest rates would further pressure the mortgage trust’s capital costs, which in turn would take a bite out of Ellington Residential Mortgage REIT’s net interest margin.

Though I think that the odds of a dividend cut are now widely reflected in the trust’s valuation, an official dividend announcement might lead to incremental selling pressure in the short term.

My Conclusion

I still own Ellington Residential Mortgage REIT and have added to my position (by 30%) in this 15% yielding mortgage trust near 52-week lows.

Though the residential mortgage-focused trust reported negative net interest income in 2023 due to a sharp increase in funding costs, I think the 21% discount to book value is exaggerated.

Furthermore, inflation is receding, which puts pressure on the central bank to keep pushing interest rates even higher. In my view, we are at or near the cyclical peak in interest rates, and a lowering of interest rates should provide crucial relief in terms of capital costs for Ellington Residential Mortgage REIT.

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