EARN - Monthly Income With Ellington Residential Mortgage REIT's 14% Yield

2023-05-12 14:17:26 ET

Summary

• The Ellington Residential Mortgage REIT yield is 14% now and will be higher if the stock falls, giving you some protection to the downside.
• Whipsaw volatility in interest rates has weighed on real estate companies like Ellington.
• Ellington Residential Mortgage stock has been flat for months, which is excellent for stable income.
• Keep an eye on distributable earnings and book value.

We have gotten defensive in this market. While select trades present themselves for our membership, we have been encouraging positions that provide income as we wait for the market to break out of this ever-collapsing range. The macro situation seems to be getting uglier by the week, but there is still hot economic data, despite some signs of slowing. If the market breaks lower, we think it presents a buying opportunity in select names.

The mortgage real estate investment trusts have been all over the place with interest rates, but Ellington Residential Mortgage REIT ( EARN ) is a mortgage real estate investment trust ("mREIT") that has been a very stable stock in all of this back and forth market action. So long as distributable earnings cover the dividend here, you can enjoy a 14% annualized yield, and get paid monthly. It is an ideal income stock, provided management can navigate the rate climate. Should rates really start to move again, it could wreak havoc, and that is a risk. The Federal Reserve's response to high inflation continues to drive markets, and the volatility in interest rates has weighed on real estate companies like Ellington that buy and sell mortgages and bundles of mortgages. However, we think that EARN dips into the $6 range can be bought here.

Eventually the rate situation will settle down and normalize, at least when it comes to curve inversion. It may take a post-recession world to get us there, but we think if the market sells off, and we think it will, scoop up some income names. Companies that are buying and selling mortgages and bundles of mortgages are struggling as the last few years have been challenging for these types of companies, from pandemic recovery to extreme rate movements, and mortgage demand pressure. On the positive side, prepayment risk has declined given the high rates on new mortgages, but spreads are all over the place, and book values have been decimated. The ongoing pressure was reflected in the just-reported earnings, but the company keeps paying its bountiful dividend and we want to be buyers. Let us discuss.

The play

Target entry 1: $6.75-$6.85 (25% of position)

Target entry 2: $6.45-$6.50 (30% of position)

Target entry 3: $6.00-$6.05 (35% of position).

NOTE: This is the type of investment entry approach we provide our members. A general strategy to generate more income in dividend names is to sell covered calls out of the money on the front month to increase your returns. We encourage members to explore those options at our investing service. But we can't give away all of the exact approaches as those are reserved for member of the BAD BEAT Investing group.

Q1 earnings

In the just reported EARN Q1 earnings , we saw interest rates settle down to start the year, but volatility spiked mid-quarter. Yield spreads were tightening further in January but by mid-February inflation concerns and the Fed's response with more hikes drove interest rates and volatility higher, and spreads widened again. Then in March, regional banking crisis spooked markets and drove a flight to safety, which put further pressure on spreads. However, book value has held up relatively well.

The one concern is that the dividend was not covered by distributable earnings. A cut to $0.07 monthly is possible which would take the yield down to a still healthy 12.2%. A summary of the critical metrics that you should be aware of for Ellington Residential Mortgage is shown below for Q1 2023:

Source: Ellington Residential Mortgage REIT's Q1 2023 Results

T able created by BAD BEAT Investing

* As of 3/31/2023

** By distributable income.

Dividend coverage is critical

So, here is our biggest concern with Ellington Residential Mortgage REIT right now. While we enjoy the stability of the stock, what could take us lower is another dividend cut. Keep in mind over the years the dividend has been cut time and again. We were not at all surprised here in Q1 2022, as the $0.08 monthly payout, or $0.24 per quarter rate, was not covered given how volatile Q1 rates were. To protect the portfolio the company has been steadily rotating out of the lowest-coupon MBS into higher MBS coupons.

We shall see how this approach plays out, but another quarter or two like this and we will see a cut. Still, we would be buying for income on the dip as prescribed above. The good news is that it looks like rate hikes are over, for now. As economic data cools, rates are held firm, and eventually cut in late 2023 or early 2024, the yield curve inversion should relax. While rough tides are in the near-term window, much better days are ahead.

Distributable income (formerly known as core income) came up short of the dividend, as we noted. This was a result of the fact that net interest margin narrowed heavily, and subsequently mREIT earnings power fell. At the end of the day, this is still an income name, so that coverage matters. The distributable earnings are the proxy for dividend coverage, as this was another tough operating environment this quarter for most all mREITs given.

Prepayments are down, and that has reduced some volatility in the portfolio, given rates are so high. With rates so high, we just are not seeing a lot of refinance activity. Ellington Residential Mortgage REIT saw a net gain of $2.3 million, or a gain of $0.17 per share. Distributable earnings were $2.8 million or $0.21 per share. However Q4, saw $0.25 per share, so the dividend may not be in immediate jeopardy, but keep an eye on it. We targeted earnings of $0.24 covering the dividend, but were not surprised when Ellington came up short. The drivers of the next few months were discussed by CEO Laurence Penn, who stated:

Given the prospect of significant bank portfolio asset sales and continued volatility, we have been judicious about adding back leverage, and we closed the first quarter with only slightly larger Agency and non-Agency MBS portfolios. Meanwhile, we continue to turn over our portfolio to improve our net interest margin and Adjusted Distributable Earnings, and we still have plenty of dry powder to take advantage of investment opportunities as the year unfolds."

So, the company is levered 7.6 to 1, which is high, but the company is being opportunistic about further moves.

We were, however, pleased to see stable book value. Book value had been falling heavily for a year straight in this environment, but recovered in Q4 and was quite stable in Q1 coming in at $8.31. With shares at $6.90, we have a $1.41 discount-to-book. This translates to a 17% discount. We like this discount. Buying at a big discount is the best way to play these names. With the $0.08 monthly dividend and our suggestion to buy into market weakness going forward, you can attain a 14-15% yield here.

Take home

Keep watching Ellington Residential Mortgage REIT distributable earnings for dividend coverage, but we like the sizable discount-to-book here and relatively stable stock price over the last few months, all things considered. Consider this name for some income on weakness.

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