Introduction
Ellington Income Opportunities (EIO) achieved a net performance of +3.80% in the second quarter1. This quarter was characterized by relatively calm markets, punctuated by periods of volatility. In June, escalating global political turmoil led to risk-off sentiment. Credit markets were negatively impacted by the selloff in European sovereign bonds and widening credit spreads. U.S. fixed income assets lagged as credit spreads, interest rates, and interest rate volatility all increased by the end of the quarter. In Q2, the U.S. Aggregate bond index returned +6.5 bps and the U.S. MBS index +6.9 bps. The fund’s core assets performed well in this environment, benefiting from lower exposure to interest rate risk and a defensive credit stance.
Market Environment
Within the Fund’s residential mortgage holdings, Credit Risk Transfer (CRT) was the largest driver of returns for the quarter. The resilience of the U.S. housing market has led to strong fundamental performance, especially in mortgage credit vintages where borrowers locked in low debt costs. Technical factors have also contributed to tighter spreads. Given strong credit performance, Government Sponsored Enterprises have sought to buy back risk in the market. In Q2, tender auctions from Fannie and Freddie repurchased $2 billion of bonds, resulting in net negative supply for the year.
The Fund’s commercial holdings performed well during the second quarter. Despite a continued selloff in interest rates, property transaction data ticked up slightly to $55 billion, up from $45 billion in Q1. Continued growth in property transaction volumes demonstrates some healthiness in the market, though higher rates continue to limit sales activity. CMBS issuance also climbed 43% over the first quarter to $28 billion, $19 billion of which were SASB deals. The credit curve flattened, widening modestly at the top of the stack while spreads on credit bonds rallied.
Within EIO’s corporate holdings, the fund’s CLOs contributed positively to returns. Continued demand for CLOs, particularly from retail fund inflows, stabilized spreads as leveraged loan prices declined modestly with broader credit markets towards the end of the quarter. Low net issuance has also supported spreads as repricing and refinancing activity accounted for a staggering 93% of total new issue loan volume in June.
The Fund’s asset-backed securities, mainly aircraft-backed securities, helped drive performance. Aircraft ABS continued to perform well in Q2 alongside a strong underlying aircraft metal market. Production issues at Boeing and Airbus have kept supply constrained, which has been supportive of lease rates and residual values. Many of our securities experienced mark to market gains and partial paydowns as the bonds continue to de-lever and outperform expectations.
Fund Outlook
Following a relatively calm period in markets,
we are now seeing a modest uptick in the dispersion of performance of structured credit asset classes. Heightened global geopolitical risks as well as uncertainties in domestic markets suggest that this trend may persist. We believe the fund is currently well positioned to capitalize on relative value opportunities between asset classes, and we are prepared to rotate positioning in response to any distressed opportunities that may arise.
Important Notes
These materials have been provided for information purposes and reference only and are not intended to be, and must not be, taken as the basis for an investment decision. The contents hereof should not be construed as investment, legal, tax or other advice and you should consult your own advisers as to legal, business, tax and other matters related to the investments and business described herein.
Fund Risks
Investing involves risk including the possible loss of principal including the following:
• Shares of the Fund will not be listed on any securities exchange, which makes them inherently illiquid.
• There is no secondary market for the Fund’s shares, and it is not anticipated that a secondary market will develop.
• The shares of the Fund are not redeemable.
• Although the Fund currently intends to offer a quarterly repurchase offer, the Fund is not required to repurchase shares at a shareholder’s option nor will shares be exchangeable for units, interests or shares of any security.
• Regardless of how the Fund performs, an investor may not be able to sell or otherwise liquidate their shares whenever such investor would prefer at the time or amount desired.
An investment in the Fund’s shares is not suitable for investors who cannot tolerate the risk of complete loss or who require liquidity.
The Fund’s investment in ABS (Asset-Backed Securities, RMBS (Residential Mortgage-Backed Securities) and CMBS (Commercial Mortgage-Backed Securities) subjects it to credit risk because underlying loan borrowers may default. Additionally, these securities are subject to prepayment risk because the underlying loans held by the issuers may be paid off prior to maturity. The value of these securities may go down due to changes in prepayment rates on the underlying mortgages or loans. During periods of declining interest rates, prepayment rates usually increase and the Fund may have to reinvest prepayment proceeds at a lower interest rate.
There is a risk that issuers and counterparties will not make payments on securities and other investments held by the Fund, resulting in losses to the Fund. In addition, the credit quality of securities held by the Fund may be lowered if an issuer’s financial condition changes. Lower-quality fixed income securities, known as “high yield” or “junk” bonds, present greater risk than bonds of higher quality, including an increased risk of default. An economic downturn or period of rising interest rates could adversely affect the market for these bonds and reduce the Fund’s ability to sell its bonds and decrease the Fund’s share price. Repayment of defaulted securities and obligations of distressed issuers is subject to significant uncertainties. Investments in defaulted securities and obligations of distressed issuers are considered speculative as are junk bonds in general.
The value of securities of smaller issuers can be more volatile than those of larger issuers. The value of certain types of securities can be more volatile due to increased sensitivity to adverse issuer, political, regulatory, market, or economic developments.
The Fund may enter into swaps and other derivative instruments which could amplify volatility. The Fund may engage in short selling for hedging and speculative purposes. A short sale may create the risk of an unlimited loss, in that the price of the underlying security
might theoretically increase without limit, thus increasing the cost of purchasing the security in order to close out the securities borrowing.
The use of leverage, such as borrowing money to purchase investments, could cause the Fund to incur additional expenses and magnify gains or losses.
A basis point (bps) is a standard unit of measurement where one basis point corresponds to a hundredth of a percentage point, equivalent to 0.01%.
Investors should carefully consider the investment objectives, risks, charges and expenses of the Ellington Income Opportunities Fund. This and other important information about the Fund are contained in the Prospectus, which can be obtained by contacting your financial advisor, or by calling 1-855-862-6092. The Prospectus should be read carefully before investing.
The Ellington Income Opportunities Fund is distributed by Foreside Fund Services, LLC, not an adviser affiliate.