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Ellington Financial (EFC) is a mortgage REIT that we cover. Today, I’d like to go over one of their preferred shares for readers.
EFC-C (EFC.PR.C) Is A Very Interesting Share
EFC-C is not a great investment choice. I would love to be able to put a bearish rating on it, but bearish ratings only really work on preferred shares if there is a strong case for the company to collapse. I do not see any reasonable argument for Ellington Financial to collapse. Therefore, I am stuck using a “Neutral” rating, even though I believe the share price is too high. Preferred shares rarely have a negative return because the price rarely fluctuates enough to lose more value than the dividends.
It’s important for investors to look at relative values of investments. The stripped yield on price is 8.66%.
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When we compare EFC-C to similar preferred shares and baby bonds, investors can find better options elsewhere. The stripped yield on this preferred share isn’t attractive relative to peers. For us to view this as a buy, the price would need to drop about $1.23. That’s more than 6 months of dividends.
Let’s consider a possible scenario. Over the next six months, the price could decline by about $1.08, which is equal to two dividend payments. The dividends they collected would be offset by the drop in price. In this scenario, investors would be seeing a total return of 0%. That still doesn’t work for us to create a bearish rating. It would be a lame performance, but not the kind of decline that works for “bearish” ratings.
That does not look at all impressive for the analyst. It looks fine for an analyst who is awful and needs something to reduce the impact of all their terrible ratings. However, for an analyst with a solid track record, having a bearish rating that delivers zero percent over six months is simply not impressive.
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Now, let’s get into why EFC-C is such a poor choice. The first issue is that the share price is nearly $25. That is too high since there is only $0.01 of dividend accrual and many cheaper alternatives. By the time this is published, the dividend accrual might be slightly higher. The shares carry a coupon rate of 8.625%. That’s not inherently bad. It’s an acceptable coupon rate. They will have the dividend rate reset when the shares begin floating. The reset will be based on the five-year Treasury rate plus 5.13%. That happens on April 30, 2028.
Unlikely Call When Shares Are Below $25
One of the challenges here is that the yield to call on these shares comes in at 8.7%, but the company has little incentive to call shares trading under the call value. Even if EFC did call the shares, it’s not particularly impressive when compared to preferred shares that currently have a stripped yield around 10%. When the shares have the dividend rate reset, it could result in a higher or lower dividend rate. Based on the current five-year Treasury rate, we would project that the dividend rate would increase at that point. However, remember that the company has the option of calling the shares at $25. If the price were to climb materially, they still might call and leave investors with the 8.7% annualized yield to call.
That is particularly relevant because most baby bonds in this sector offer annualized yields to call and maturity above roughly 8% to 9%. Since baby bonds rank higher than the preferred shares in the capital structure, they are considered safer. Further, because the maturity date is forced, investors know that there is a set date upon which they should get their principal back. That leads to less volatility in the share price. For investors who are monitoring overall portfolio volatility as part of their risk profile, it makes the baby bonds more attractive in many cases. For investors specifically interested in Ellington Financial, there is not a baby bond option. There are only the preferred shares. However, there are many peers to Ellington Financial that have issued baby bonds.
Among the mortgage REIT preferred shares we cover with risk ratings of 2.5 or above, EFC-C carries the highest price. There are plenty of better choices, in our opinion, at this risk level and yield.
Something To Think About
In my opinion, investors in EFC-C should generally be looking for opportunities to reallocate to a more favorably valued preferred share or baby bond. There are many options, and we cover them quite frequently in our articles on Seeking Alpha. I wouldn’t be inherently bothered by the 8.6% yield if there were no better options. However, there are currently many better options with a lower risk rating and a higher yield.
I’m sticking with the neutral rating because I don’t see a strong case for the share price to decline by a large enough margin to make a bearish rating look good. The decline would need to be materially larger than the dividends; otherwise, it would be a very mediocre rating.
The most likely scenario for the next year is that investors receive a return roughly in line with the stripped yield. That doesn’t sound bad to most investors if they simply imagine getting a return that is around 8.6%. However, there are many other options within this sector where the investor would be expecting to earn a return in the high 8% range up to about 10%.
For investors that are looking in this space, you could look at AGNC Investment Corp (AGNC) preferred shares to earn a yield over 9%. We view AGNC preferred shares as carrying less risk with a risk rating of 2. If investors are willing to take on slightly more risk, the Rithm Capital (RITM) preferred shares have more than one preferred share offering over a 10% stripped yield.
