Orchid Island Capital: Tempting 18% Yield But Stay Far Away From This Island!

Jun. 03, 2022 3:46 PM ETOrchid Island Capital, Inc. (ORC)AGNC, DX, NLY35 Comments10 Likes
Damon Judd profile picture
Damon Judd
793 Followers

Summary

  • ORC pays out a high yield monthly dividend that amounts to nearly 18% at the current market price.
  • The 5-year, 1-year, and YTD total returns for ORC are dismal and even worse than most of their peer mREITs.
  • With the pending plan by the Fed to sell off MBS and Treasuries, the prospects for ORC going forward are not good and investors should avoid this stock.

Buy or sell REIT concept

Maria Vonotna/iStock via Getty Images

With interest rates rising and mortgage rates now above 5% after hovering near or under 3% for many months, the housing market is starting to show signs of softening. Home sellers are starting to lower their asking price, active listings are down, pending home sales are falling, and this is typically the most active time of the year for the housing market. Mortgage rates have not been this high since 2011.

Rising Mortgage Rates

Rising Mortgage Rates (Freddie Mac (Yahoo Finance))

Mortgage demand and applications for new mortgages are also falling to the lowest level since 2018, even as rates start to recover slightly. Even refinance applications are down because many people already refinanced when rates were lower last year.

Mortgage REITs are feeling the blow from inflationary pressures and fewer mortgages and refinance loans. One of those companies is Orchid Island Capital (NYSE:ORC), which I wrote about in January and cautioned investors to stay away because of declining book value, and margin compression due to rising rates. In that article, I mentioned the triple threat of rising rates, the Fed's plan to reduce the balance sheet, and cutting bond purchases.

From March 2020 through March 2022, the Fed was purchasing about $80B per month in Treasuries and $40B in agency MBS. Overall, securities holdings more than doubled in that 2-year period from about $3.9 Trillion in March 2020 to $8.5 Trillion in May 2022.

The latest plan by the Fed is to start trimming bond purchases and selling MBS (mortgage-backed securities) using a phased-in approach.

The Committee intends to reduce the Federal Reserve's securities holdings over time in a predictable manner primarily by adjusting the amounts reinvested of principal payments received from securities held in the System Open Market Account (SOMA). Beginning on June 1, principal payments from securities held in the SOMA will be reinvested to the extent that they exceed monthly caps.

For Treasury securities, the cap will initially be set at $30 billion per month and after three months will increase to $60 billion per month. The decline in holdings of Treasury securities under this monthly cap will include Treasury coupon securities and, to the extent that coupon maturities are less than the monthly cap, Treasury bills.

For agency debt and agency mortgage-backed securities, the cap will initially be set at $17.5 billion per month and after three months will increase to $35 billion per month.

Investor Appetite for High Yield Income

In the current market environment with inflation soaring above 8% and interest rates rising, many investors are seeking high yield investments. That is one reason why mREITs are often considered. Generally speaking, the mortgage REIT business model is able to generate a high level of income to be delivered to shareholders because they are required to pay out a minimum of 90% of their profits as non-qualified dividends.

Meanwhile, since the start of 2022, ORC has cut the dividend twice, first in January from $0.065 to $0.055 and then again in March from $0.055 to $0.045. As of June 2, 2022, the closing price was $3.15 so the monthly dividend, declared in-line for May at $0.045, works out to nearly an 18% annual yield if they keep the next 7 monthly distributions the same. The latest dividend cuts are not just a recent phenomenon either. The dividend payout has been on a general decline since shortly after the company went public in 2013.

ORC Dividend History

ORC Dividend History (Q1 Earnings Presentation)

The 18% forward yield gives many investors an appetite to bite into such a juicy opportunity. But that is not necessarily the best use of your hard-earned investment dollars, in my opinion. The super high yield is due to a steadily dropping stock price. In fact, the investor relations website for ORC includes a heading that reads "Why Invest?". And the first thing that I read on that page is the 5-year total return of (9.3%) as of 12/31/21.

Why Invest in ORC?

Why Invest in ORC? (ORC Investor Relations Website)

I am not sure that I would advertise that statistic in big bold text on my investor relations website. And it gets worse - the TR since the start of 2022 has not gotten any better! The YTD total return is -24.74% compared to the S&P 500 at -11.79%.

YTD total return

YTD Total Return (Seeking Alpha)

At this point, some might think that the worst is over now, and things will start to get better. Au contraire. On April 28 the Q1 earnings report revealed a huge net loss of $148.7 million or -0.84 per common share (a miss of negative $0.51 per share compared to consensus GAAP estimates). Book value declined to $3.34 as of March 31, 2022. The book value in Q4 2021 was reported at $4.34 (versus $5.46 in Q4 2020).

And the Fed has not yet begun to reduce its holdings, which is likely to have an additional negative impact on ORC's bottom line when they do. The impacts in Q1 from Covid lockdowns, inflationary pressures, rising rates, and the war in Ukraine had a "profound and rapid" impact on Agency RMBS, according to the ORC press release. Naturally, the company took steps to address these impacts:

The impact of these developments on the Agency RMBS market was profound and rapid. Levered RMBS investors such as Orchid that invest solely in the Agency RMBS market have limited options to avoid these headwinds. However, we took advantage of every option we had to minimize the impact and are well positioned to take advantage of the opportunities in the Agency RMBS market that will exist when the market stabilizes. We repositioned our hedge positions, and we have reduced the size of the portfolio through outright asset sales and retaining cash received from our monthly paydowns. Our leverage ratio declined from 8.1 to one at the end of 2021 to 7.5 to one at the end of the first quarter of 2022, and is even lower today. We have increased the allocation to the structured securities, interest only portfolio. We have maintained ample liquidity at all times and retained cash balances equal to approximately 50% of our shareholders equity throughout. We took the painful step of reducing our dividend in response to the compression of the gap between our funding costs and asset yields.

Admittedly, the first quarter of 2022 was tough on all asset classes, not just RMBS. But the market is not yet stabilizing, so in my opinion, there is likely further pain to be felt in Q2 and probably Q3 as well. The company is still highly leveraged at 7.8 to 1 as of March 31 with $4,464.1 million in outstanding repurchase obligations and only about $301M in liquidity.

Capital Allocation and Returns on Invested Capital

The company allocates capital to two RMBS sub-portfolios. One is referred to as the "Pass Through" portfolio that consists of pass-through certificates issued by the GSEs (Fannie Mae, Freddie Mac, or Ginnie Mae) and CMOs (collateralized mortgage obligations) issued by the GSEs. The other portfolio is called the Structured Portfolio and includes interest only and inverse interest-only securities. As of March 31, 2022, the PT portfolio made up over 61% of the total while the Structured portfolio was ~38%. The ROIC for the PT portfolio during the first quarter of 2022 was an astonishing -32.4% while the smaller Structured portfolio returned 9.1% for a combined negative return of -20%.

Stock Offerings and Repurchases

The company is authorized from time to time to issue new shares of common stock in "at the market" offerings.

Through March 31, 2022, we issued a total of 15,835,700 shares under the October 2021 Equity Distribution Agreement for aggregate gross proceeds of approximately $78.3 million, and net proceeds of approximately $77.0 million, after commissions and fees.

In 2015 the Board authorized up to 2M shares to be repurchased and increased the number in 2018 and then again in December 2021. The total number of shares authorized to repurchase was increased to 17,699,305 shares, representing approximately 10% of the Company's then outstanding shares of common stock. The company did not repurchase any shares during the first 3 months of 2022 despite the stock price plummeting to all-time lows.

In other words, they issued almost as many new shares during the quarter, as the number of existing shares authorized to be repurchased.

The outlook for the remainder of 2022 does not look promising either. The expected FFO (Funds From Operation) is expected to decline over the next several quarters.

ORC Funds From Operation

ORC Funds From Operation (Seeking Alpha)

With the intended plan by the Fed to leave the MBS market and reduce bond buying over the next several months, there are not too many silver linings that I can find in ORC's future. This paragraph summarizes how the Fed's plans impact the MBS investment space that ORC operates in:

Also important for this new cycle, is that the Fed is no longer directly supporting the mortgage market by purchasing Mortgage-Backed Securities (which helps to keep that market liquid). This means that a reliable buyer of these instruments -- and one that did not care about the level of return on its investment -- has left the market. This leaves only private investors who care very much about making profits on their holdings, and a range of risks to the economic climate may make them more wary of purchasing MBS, particularly at relatively low yields. At the same time, the Fed is no longer purchasing Treasury bonds to help keep longer-term interest rates low, and so the influential yields on these instruments have risen somewhat as a result.

In essence, I do not see how the de-leveraging efforts are going to be enough to right the ship and begin to increase the book value for ORC when these other market factors are in play over the next few months. It could take as long as five years for the Fed to reduce the balance sheet according to some, but at a minimum, it is likely to take at least until the end of 2023.

Fed planned monthly reductions

Fed planned monthly reductions (St. Louis Fed)

Comparison to Peers

You might think that all mREITs are having a tough time this year and that is generally a correct assumption. Some peers include Annaly Capital (NLY), AGNC Investment (AGNC), and Dynex Capital (DX). All of them have struggled so far in 2022 and all except DX have a negative TR to date, however, ORC is the worst of the bunch.

comparison to peers

Comparison to peers (Seeking Alpha)

Even by their own admission, ORC has been underperforming their peers since inception, and especially so in the past year. I am not even sure that I understand why they would include this slide in their earnings presentation.

peer stock price performance

Peer stock price performance (Q1 earnings presentation)

Ratings and Opinions

Surprisingly (to me at least), Wall Street analysts give ORC 1 Buy and 1 Hold rating. According to Yahoo Finance, JonesTrading upgraded ORC from Hold to Buy, while JMP Securities initiated the stock at Market Perform in January of this year. About 21% of the float is held by institutions such as BlackRock, Vanguard, State Street, and others.

Several articles by other authors on SA over the past year have also been pessimistic regarding the investment opportunity for ORC, including this article from February with a Strong Sell rating. On the other hand, there is some belief that rising rates are a positive for mortgage REITs as it enables them to increase the spread between borrowing and lending. Traditionally, with the backing of the Fed in purchasing MBS, this has reduced the risk for mREITs. This is one reason why investors like the high yield as they believe that those profits are at less risk with the backing of the Fed. But with the current plans by the Fed to reduce MBS purchases going forward that risk is becoming elevated.

I would recommend avoiding ORC as a new investment. If you are already a shareholder you may wish to hold your shares and collect the dividend, but I would not recommend adding any more at this point. The worst may be in the past now, but given all the factors described above and the state of the economy in 2022, it is not the best place to park your investment dollars.

This article was written by

Damon Judd profile picture
793 Followers
Visit www.Knowledge-Investing.com for more info about me. I became deeply interested in the stock market beginning in late 2007 (bad timing for me but worse for my uncle) when I received an unexpected inheritance. Since that time I have done considerable research and vowed to make smarter long-term investing decisions after suffering through the Great Recession with minimal losses to my inherited portfolio, after firing my financial advisor.I look for individual growth and income stocks, and some funds (CEFs, ETFs) that offer high yield income to increase my retirement income beyond my 401k and the pension that I will receive after I retire. I also enjoy reading investment/financial and business information and following trends in technology and markets. The human psychology of markets is as fascinating and inscrutable to me as the financial side. I work as an information systems manager, so data and information are valuable assets to me. I am not a financial advisor so please do your own due diligence before making any buy or sell decisions.“The race is not always to the swift, nor the battle to the strong, but that's the way to bet.” Damon Runyon
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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