Orchid Island Capital, Inc. (ORC) is a real estate investment trust (REIT) that invests primarily in residential mortgage-backed securities (RMBS). The company's investment strategy focuses on two categories of Agency RMBS: traditional pass-through Agency RMBS and structured Agency RMBS, such as interest-only securities (IOs) and inverse interest-only securities (IIOs). Orchid's objective is to provide attractive risk-adjusted total returns over the long term through a combination of capital appreciation and the payment of regular monthly distributions.
Orchid's Storied History and Continuous Evolution
Orchid Island Capital was incorporated in Maryland on August 17, 2010, with the purpose of creating and managing a leveraged investment portfolio consisting of residential mortgage-backed securities (RMBS). The company commenced operations on November 24, 2010, with the issuance of common stock to its parent company, Bimini Capital Management, Inc. (Bimini). Orchid remained a wholly-owned subsidiary of Bimini until its initial public offering (IPO) on February 20, 2013, when it listed its common stock on the New York Stock Exchange under the ticker symbol ORC.
Throughout its history, Orchid has utilized various equity distribution agreements to raise capital. In October 2021, the company entered into an agreement with four sales agents, allowing it to offer and sell up to $250 million of shares of its common stock. Under this agreement, Orchid issued 9.74 million shares for aggregate gross proceeds of approximately $151.8 million before terminating the agreement in March 2023. Subsequently, in March 2023, Orchid entered into a similar agreement with three sales agents, resulting in the issuance of 24.68 million shares for aggregate gross proceeds of approximately $228.8 million before termination in June 2024.
In addition to raising capital, Orchid has implemented a stock repurchase program. Initiated on July 29, 2015, with an initial authorization to repurchase up to 400,000 shares, the program has been expanded multiple times. As of October 2022, the total authorization reached 6.18 million shares, representing approximately 18% of Orchid's then-outstanding shares. From the program's inception through September 30, 2024, Orchid repurchased a total of 5.14 million shares, demonstrating its commitment to enhancing shareholder value.
Since its inception, Orchid has demonstrated a remarkable ability to navigate challenging market conditions. During the COVID-19 pandemic in 2020, the company successfully weathered significant market volatility, posting a net income of $2.13 million for the full year. In 2021, Orchid continued to adapt, raising $514.06 million through equity issuances and generating $96.44 million in free cash flow.
In 2022, the company faced more turbulent times, reporting a net loss of $258.45 million as rising interest rates and market uncertainty weighed on its portfolio. However, Orchid's management team demonstrated its resilience, raising an additional $40.58 million in equity and generating $289.37 million in free cash flow.
Navigating the Market Landscape in 2023 and 2024
The market environment remained challenging in 2023, with Orchid reporting a net loss of $39.23 million for the full year. However, the company continued to execute its diversified investment strategy, raising $159.44 million in equity and maintaining a healthy free cash flow of $8.00 million.
As the market navigated the volatile landscape in 2024, Orchid's performance has been mixed. For the nine months ended September 30, 2024, the company reported net income of $32.12 million, or $0.53 per share. This was a significant improvement from the $66.35 million net loss reported in the same period of 2023. The company's book value per share declined modestly from $8.58 to $8.40 during the third quarter of 2024, while the total return for the quarter was a positive 2.1%.
Orchid's Diversified Investment Approach
Orchid's investment strategy is centered around two categories of Agency RMBS: traditional pass-through Agency RMBS and structured Agency RMBS. This diversified approach allows the company to manage interest rate risk and market volatility more effectively.
The traditional pass-through Agency RMBS portfolio is primarily composed of fixed-rate mortgages, which generate a stable stream of income. The structured Agency RMBS portfolio, including IOs and IIOs, provides exposure to securities with different risk and return characteristics, helping to mitigate the impact of interest rate movements on the overall portfolio.
As of September 30, 2024, Orchid's RMBS portfolio had a weighted average coupon of 4.90% and a weighted average maturity of 325 months. The portfolio was diversified across Fannie Mae (67.8%) and Freddie Mac (32.2%) securities. The fixed-rate RMBS in this category had a fair value of $5.43 billion, representing 99.7% of the total RMBS portfolio. The fair value of the IO securities was $15.38 million, and the fair value of the IIO securities was $353,000, together representing 0.3% of the total RMBS portfolio.
During the nine months ended September 30, 2024, the company received $310.3 million in principal repayments from the RMBS portfolio. In the third quarter of 2024, Orchid increased its portfolio by around 20% by acquiring higher coupon mortgages (6%, 6.5%, and 7% coupons). This strategic move increased Orchid's weighted average coupon from 4.72% to 4.94%, and the yield on the portfolio expanded from 5.05% to 5.43%.
Navigating Market Volatility through Hedging Strategies
Orchid actively manages its interest rate risk through the use of various hedging instruments, including T-Note, SOFR, and Fed Funds futures contracts, short positions in U.S. Treasury securities, interest rate swaps, swaptions, and dual digital options. These strategies help the company mitigate the impact of interest rate fluctuations on its portfolio and funding costs.
As of September 30, 2024, Orchid had $3.49 million in notional value of interest rate swaps, with an average fixed pay rate of 2.78% and an average receive rate of 5.37%. The company also had short positions in 10-year T-Note futures contracts with a notional value of $14.30 million and short positions in SOFR futures contracts with a notional value of $1.24 billion.
Orchid's Funding and Leverage Strategies
Orchid finances the acquisition of its RMBS portfolio primarily through the use of short-term repurchase agreements. As of September 30, 2024, the company had $5.23 billion in repurchase agreement obligations, with a net weighted average borrowing cost of 5.24%.
Orchid's leverage, as measured by its economic leverage ratio, was 7.60 to 1 as of September 30, 2024, compared to 6.70 to 1 as of December 31, 2023. The company's adjusted leverage ratio, which measures repurchase agreements to stockholders' equity, was 8.00 to 1 as of September 30, 2024, compared to 7.90 to 1 as of December 31, 2023.
The company noted the possibility of reducing leverage going forward if rates continue to rise, in order to maintain their high dividend yield.
Financials
Orchid's financial performance has been subject to market volatility and interest rate fluctuations. For the nine months ended September 30, 2024, the company reported net income of $32.12 million, a significant improvement from the $66.35 million net loss in the same period of 2023. The company's book value per share declined modestly from $8.58 to $8.40 during the third quarter of 2024.
In the most recent quarter (Q3 2024), Orchid reported revenue of $68,156,000 and net income of $17,320,000. The operating cash flow (OCF) and free cash flow (FCF) for the quarter were both negative at ($14,824,000). The company had a net income of $0.24 per share in the third quarter of 2024, compared to a $0.09 loss in the second quarter.
Orchid's funding costs dropped by around 30 basis points in September due to the Federal Reserve's 50 basis point rate cut. The company expects modest net interest margin (NIM) expansion going forward due to the higher coupon portfolio and slightly lower funding costs.
Liquidity
Orchid maintains a strong liquidity position to support its operations and investment activities. As of September 30, 2024, the company had $322.11 million in cash and cash equivalents, in addition to $99.47 million in U.S. Treasury securities classified as available-for-sale. These U.S. Treasury securities are primarily held to satisfy collateral requirements of its repurchase agreement and derivative counterparties.
The company's balance sheet also generates liquidity through the payment of principal and interest received on its RMBS portfolio. During the nine months ended September 30, 2024, Orchid generated $459.40 million in cash flows from its RMBS investments.
While Orchid has access to repurchase agreement funding facilities, the company does not disclose the specific amounts of available credit lines.
Orchid's Dividend and Shareholder Returns
Orchid is organized and operated to qualify as a REIT, which requires the company to distribute at least 90% of its REIT taxable income to its stockholders annually. The company has a history of paying regular monthly dividends to its shareholders.
For the nine months ended September 30, 2024, Orchid declared dividends totaling $1.20 per share. The company's dividend yield, based on the September 30, 2024 closing price of $6.44 per share, was 18.43%. In the third quarter of 2024, Orchid declared $3.12 in dividends.
Risks and Challenges Facing Orchid
Like any investment, Orchid's business model and operations are subject to various risks and challenges. Some of the key risks facing the company include:
- Interest Rate Risk: Orchid's RMBS portfolio and funding costs are sensitive to changes in interest rates, which can impact the company's net interest income and book value.
- Prepayment Risk: Residential borrowers have the option to prepay their mortgage loans at any time, which can affect the yield and duration of Orchid's RMBS portfolio.
- Spread Risk: Widening spreads between the yield on Orchid's Agency RMBS and benchmark interest rates can negatively impact the company's net book value.
- Liquidity Risk: Orchid's reliance on short-term repurchase agreements to finance its RMBS portfolio exposes the company to potential liquidity challenges if market conditions deteriorate.
- Regulatory and Policy Changes: Changes in government policies, regulations, or the structure of the housing finance system could have a significant impact on Orchid's business and operations.
Outlook and Conclusion
Orchid Island Capital has demonstrated its ability to navigate challenging market conditions through its diversified investment approach and active risk management strategies. The company's performance in 2024 has been mixed, with net income of $32.12 million for the nine months ended September 30, 2024, but a modest decline in book value per share during the third quarter.
Looking ahead, Orchid will continue to face a volatile and uncertain market environment, with factors such as interest rate movements, prepayment trends, and regulatory changes posing ongoing risks. The company noted that there is still uncertainty around the economy and the upcoming election, which could impact rates and the mortgage market.
However, the company's experienced management team, diversified portfolio, and focus on risk management suggest that Orchid is well-positioned to weather these challenges and continue providing attractive risk-adjusted returns to its shareholders. The strategic move to increase the portfolio's weighted average coupon and the expected modest net interest margin expansion provide some optimism for future performance. Nonetheless, Orchid remains cautious about the outlook and is prepared to adjust its strategy, including potentially reducing leverage, in response to changing market conditions.