Long focused on agency mortgages and to a lesser degree on collateralized loan obligations (CLOs), Ellington Residential Mortgage REIT began acquiring CLO mezzanine and equity tranches in its portfolio in fall 2023 to diversify assets. The next year, it surrendered its real estate investment trust (REIT) status and began pursuing a conversion to Ellington Credit Company (EARN), a closed-end fund focused on the CLO market.
The conversion became official April 1, 2025, and the next day its executives rang the NYSE's closing bell. The timing proved fortuitous, because soon after President Trump announced reciprocal tariffs, spiking financial volatility. Still in the process of converting investments, however, Ellington held significant liquidity on its books.
"After the initial selloff in the markets, we had the liquidity to invest opportunistically," said Gregory Borenstein, portfolio manager at EARN and head of corporate credit at Ellington Management Group (EMG), the investment management firm behind EARN.
Borenstein joined EMG in 2012 to grow the firm's CLO capabilities following five years at Goldman Sachs where he traded CLOs and structured credit. He recently spoke to Asset Securitization Report (ASR) about the CLO-market outlook and the risks that keep Ellington vigilant.
ASR: What prompted the move to CLOs?
Borenstein: We thought the transition would better position the company for future growth and broader access to the capital markets.
ASR: What type of CLO paper does EARN invest in now?
Borenstein: We see a nice balance between equity and mezzanine, and at different points in time have leaned differently between them. Last year, equity had a tough time with demand compressing loan spreads, as well as some tail-risk problems resulting in losses. That level of dispersion is not good for the first-loss, equity tranche of CLOs, because if overall things are going well but there's a handful of issues, you're still exposed to them.
ASR: How has that impacted your investment approach?
Borenstein: We've been tepid in how we're managing our allocations to equity, and so over the past year and a half we've preferred more junior mezzanine paper, in the BB range. New issue equity remains fairly unattractive, because the arbitrage doesn't necessarily offer the best risk-adjusted return. While demand for loans has tightened spreads on the asset side, so much supply on the structured side hasn't allowed liabilities to come in enough to create an equity profile and return we think is attractive.
That said, earlier this year we started to see potentially interesting equity opportunities in secondary market trading.
ASR: Why is mezzanine more attractive?
Borenstein: There generally isn't much discount but you are getting coupons close to or above double-digits, and you have subordination and test protections. Generally, you don't need to be concerned about being made whole in light or moderate stress. We think that compared to other credit products, the return for the risk and liquidity can make sense for a portion of the mezz universe. A lot of this comes down to your assumptions and how you see factors like default rates, prepayment and recovery rates, and how your investment strategies move through time.
ASR: Where are you seeing equity opportunities in the secondary market?
Borenstein: Areas that have been oversold, and a lot of what we try to do is assess the risk-adjusted return. Sometimes the tighter-spread you're getting on a quality name in the CLO market has provided a better risk-adjusted return than a loan trading at a better yield that may be riskier.
Also, CLO manager quality. A good quality manager will have greater ability to come into the market and tighten the CLO's liabilities, in the same way quality loan issuers can [tighten spreads]. One CLO may trade a little wider than the other, but when they come out of their non-call periods, the tighter one may actually reset to a wider yield [for equity] because it can bring in its liabilities so much more. Managers with wider liabilities may need to take more credit risk on their assets to be able to make the equity profile work. You have to see the forest through the trees on what the actual risk is.
ASR: How do you define quality managers?
Borenstein: There are many third-party analytics available now to evaluate managers, whether the spreads of the underlying asset pool or its ratings, the number of CCC loans they own, or the par-loss their deals have experienced. But CLOs aren't standardized, so as much as we underwrite managers you also have to assess structures. One CLO may have an over-collateralization test that shuts off quicker, so cash-flow proceeds and the sub-management fees to the equity may be diverted quicker--not great for the equity but it may [be] good for the mezzanine because debt is protected quicker in a stress situation.
Managers may also have different styles. Some managers may tend to reinvest into more aggressive, "spreadier" assets while others are comfortable allowing deals later in their life to prepay and de-risk. Platforms can change in performance and style based on who is the head portfolio manager.
ASR: What factors raise a red flag?
Borenstein: Simply put, market-value coverage—the market value of the underlying pool and the degree to which each tranche is covered. If you liquidate all the underlying assets and can't pay off the rated debt, that pops out as problematic.
You also don't want very heightened CCC levels, so even if the overall pool looks great a handful of tail names can negatively impact the equity. And if there's very low transparency [into the assets], is the manager starting invest in the quasi-private, middle-market, less liquid names? A nice thing about CLOs historically is that the loans have transacted and have bids and real pricing information.
ASR: Do you invest in middle-market CLOs?
Borenstein: When we invest in middle-market or private-credit CLOs, we tend to not go as far down the capital structure because it's harder to get comfortable with the collateral information. We're much more reliant on trusting the manager's track record.
ASR: Does the issue of software obsolescence raise concerns?
Borenstein: Yes, if a CLO has a large concentration in a sector facing challenges, and if concerns prompt the rating agencies to downgrade the sector, that can put pressure on loan prices. In software a lot of names became un-investable for CLOs. We're keeping an eye on sectors such as building products, with higher interest rates and secular headwinds, and containers and packaging in terms of their leverage.
ASR: What about the risk of inflation, more generally?
Borenstein: If interest rates increase, you're upping borrowing and input costs, and you're stressing debt servicing and interest coverage. And because it's floating rate, that flows through directly. That's a concern if you're CLO equity because, again, you don't need everything to go wrong, just if there are problems in the tail.
