Description

Ellington Financial (EFC) is principally a credit-focused mortgage REIT. The common stock of EFC was last written up on VIC in 2012. See https://www.valueinvestorsclub.com/idea/ELLINGTON_FINANCIAL_LLC/8537580886#description for a background on the company. We believe the company’s newly issued Preferred Stock Series C is an attractive investment with a 9.5% dividend yield, which is an attractive yield relative to its A- rating by Egan-Jones. While we also like the common stock equity of EFC, we like the Series C at these yields given its higher position in the capital structure.

Series C Preferred Stock Summary of Terms

The basic terms of EFC’s 3 preferred stock can be found below:

https://www.quantumonline.com/search.cfm?tickersymbol=EFC-C&sopt=symbol

https://www.quantumonline.com/search.cfm?tickersymbol=EFC-B&sopt=symbol

https://www.quantumonline.com/search.cfm?tickersymbol=EFC-A&sopt=symbol

Ellington Financial Inc. Series C Fixed-Rate Reset Cumulative Redeemable Preferred Stock, liquidation preference $25 per share, redeemable at the issuer's option on or after 04/30/2028 at $25 per share plus accrued and unpaid dividends, and with no stated maturity. The coupon is $2.15625 per share.

Cumulative distributions of the Annual Fixed Dividend Rate will be paid quarterly on 1/30, 4/30, 7/30 & 10/30 to holders of record on the record date fixed by the board, not more than 60 days or less than 30 days prior to the payment date (NOTE: the ex-dividend date is one business day prior to the record date). The Annual Fixed Dividend Rate will be 8.625% until the first redemption date, then it will be equal to the sum of the five-year treasury rate on the applicable fixed rate calculation date plus 5.13%, resetting every 5 years thereafter on applicable fixed rate calculation date (see prospectus for more details).

This security was rated as A- by Egan Jones Ratings Co. at the date of its IPO. In regard to the payment of dividends and upon liquidation, the preferred shares rank junior to the company's senior debt, equally with other preferreds of the company, and senior to the common shares of the company. 

Attractive Yield and Mispricing

The Series C Preferred Stock is trading at a 9.5% yield versus around 7.6% and 7.9% for the Series A and Series B, respectively. None of the preferred stock yields are currently floating and similarly situated on the capital structure so they should be trading at similar yields. Yet, the Series C is trading at much higher yield compared to the Series A and B. 

If Series C traded at a yield similar to the other two EFC preferred stocks, then it would be taking at a premium to par. We are not underwriting such a scenario. In a base case scenario, we expect it to trade at par, which would mean a total return of 20%+ in a year (dividend + capital appreciation). A good comp for the Series C (other than the Series A & B of EFC) is Rithm Capital's 4 preferred stocks, Series A through D (RITM). Rithm's 4 preferreds are trading in the 8%-8.3% yield range. This provides a sanity check on whether the target yield for EFC Series C at par is reasonable.

The Series C is also attractively priced relative to A rated bonds. The yield on A rated bonds is currently about 5.4%. One may take issues with whether a A- rating by Egan-Jones is warranted, but the spread on the Series C relative to A rated bonds is quite wide. 

The natural question is why the Series C is priced at these levels. Mortgage REITs common and preferred stock securities are largely owned by retail investors, passive funds, and wealth managers - generally a group of investors more interested in collecting their quarterly dividends rather than actively trading these instruments. The size of the issue is relatively small ($100mil) with limited trading volume. Given the small size of the issue and the investor base, the mREIT preferreds are not always efficiently priced in the market. The Series C started trading in early February 2023 and sold off into the SVB banking crisis and the rate volatility in the early part of this year and hasn’t fully recovered. It’s not surprising that some weak hands who bought in the offering sold into this environment, driving down the price.

Top-Notch Management Team and Superior Risk Management

Preferred stock securities of leveraged financial companies have numerous risks, such as interest rate risk, spread risk, mark-to-market risk, and dividend reductions. We have high regard for the management team running EFC and feel the various risks, even some of the macro risks, are well mitigated by this exceptional team.

We have been following the management team since the financial crisis in 2009. EFC is externally managed by Ellington Financial Management (EFM), a top-notch investment firm in the mortgage and fixed income industry. Here’s a summary of the organization:

The investment team at EFM led by Michael Vranos, a well-respected veteran investor in the sector, manages multiple billion in AUM in various private funds and in two publicly traded mortgage REITs, EFC and EARN. More information on the key managers of the team can be found at https://www.ellingtonfinancial.com/team. The key team has been working together for 20+ years. We’ve found the team to be straightforward, level-headed, and intellectually honest. They are very much value investors at heart.

They have a very deep understanding of the consumer and mortgage credit space and do very detailed analysis of all the assets they purchase using proprietary tools and data they’ve developed over time actively trading all different types MBS and pass-through securities, agencies, non-agencies, IOs, multi-family, pay-ups, etc. They drill down deep into the asset backed securities they purchase and analyze them on a granular level, not only by state or county but also down to the census tract or individual collateral level, using their proprietary tools. 

They have an impressive track record of managing the company over two harrowing market cycles over the last 15 years. Their active hedging and portfolio management allowed them to protect book value and generate attractive yields even during the 2008-2009 financial crisis and the 2020-2022 pandemic. If a management team can handle the implosion of the MBS market during the financial crisis and the fixed income market turmoil during the pandemic, they should be able to weather future economic storms. We also like the significant insider ownership of EFC at 6%, which has remained relatively stable over time. This following chart highlights how well the team has performed over time in managing the book value of the company. 

EFC manages a diversified book of consumer and mortgage related credit assets as well as some agency mortgage assets. They run at a relatively low leverage ratio of 2.1x debt-to-equity on a recourse basis. Compared to other firms in the industry, EFC has always very actively managed their assets and hedging. They dynamically hedge interest rate risk and credit risk using various derivative instruments. The active hedging has resulted in much more stable economic returns than comparable firms in the hybrid mREIT space.

Additional information on the assets, liabilities, and hedging can be found on the most recent 1Q23 earnings presentation:

https://www.ellingtonfinancial.com/static-files/ebeb47f3-ba80-4f9d-bf92-7dbd68734e51 

Conclusion

Given the strong track record of the management team, we feel the team will be able to continue to manage the business conservatively to preserve book value, generate attractive yields, and handle the various risks in operating a leveraged financial company. Overall, the EFC Series C Preferred Stock is trading at an attractive yield on an absolute basis and also on a relative basis and has the potential for 20%+ returns as it trades back up to par.

Risks

- Interest rate risk

- Spread widening

- Liquidity risk

- Dividend suspension

- Recession

Legal Disclaimer: This research report expresses my research opinions, which I have based upon certain facts, all of which are based upon publicly available information. Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimates are for illustrative purposes only and should not be taken as limitations of the maximum possible loss or gain. Any information contained in this report may include forward-looking statements, expectations, and projections. You should assume these types of statements, expectations, and projections may turn out to be incorrect. This is not investment advice nor should it be construed as such. You should do your own research and due diligence before making any investment decision with respect to securities covered herein. The author and/or his employer has a position in this stock and may trade this stock.

Catalyst

- Dividends

- Investors starting to appreciate the relative value in the Series C

- Redemption at par in 2028

- Rate cuts