In April, I wrote “Assessing Survival Potential: Orchid Island Capital Has A Major ‘Fed Put'”, which explained my bullish stance on the mortgage REIT Orchid Island Capital (ORC). Since then, the stock has delivered about 40% in total returns and drawn much closer to its fair value. The economic backdrop has also deteriorated a bit, and the Federal Reserve has slowed its pace of mortgage-backed security purchases. Thus, I believe investors would be wise to take some money off the table in Orchid and in other mortgage REITs.
To review, Orchid Island Capital invests primarily in pass-through residential mortgage-backed securities which are backed by a federally charted agency. These are mortgages that are insured against default by the likes of Fannie Mae (OTCQB:FNMA) or others. The RMBS ETF (MBB) by iShares holds essentially the same assets.
The major difference between Orchid Island Capital and an ETF like MBB is that Orchid uses extremely high leverage in order to generate an outsized income return and also hedging to limit exposure to interest rates. Orchid currently has a very attractive forward dividend yield of 14.6%. It is also likely trading below its net asset value, which the company recently estimated to be between $5.3 and $5.4 per share (over 25% above its current price).
Value Remains, But The Opportunity Has Faded
Still, I’m more cautious about the company than I was in April. Back then, the stock was trading below $3, and it recently collapsed during the March fire-sale. Orchid Island Capital had recently been caught in a margin call after the RMBS market went through a liquidity shortage and rapidly declined in value. The company took a $28.4 million realized loss on the $1.8 billion RMBS portfolio it had sold, and many investors were worried it would be forced into full liquidation. The company took a $91 million loss in Q1 overall.
Of course, the Federal Reserve had stepped in to purchase these securities on the open market through its QE program. This very quickly lifted RMBS securities to their pre-crash level and made Orchid a buoyant firm again. At the time, the stock price did not reflect this reality, but it seems to today.
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The course of events is illustrated below:
As you can see, MBS securities crashed, Orchid Island Capital lost almost all of its value, and then the Federal Reserve stepped in to directly support the market and Orchid rebounded. Orchid has not seen a full rebound despite the rebound in MBS securities, since it lost a large portion of its assets during the crash and its dividend was cut substantially.
The above chart shows my originally long thesis for Orchid Island Capital, but it also explains my reason for taking profits. The pace of Federal Reserve purchasing has slowed considerably, and MBS securities have been on the slight decline. Mortgage rates have also continued to decline, which, though it may partly improve asset values, could cause the company to buy assets at too high a price going forward as its net interest margin is put under pressure.
There is also the fact that around 8-9% of U.S mortgages are currently in forbearance. It is generally expected that these mortgages will become performing as the economy rebounds. However, recent events regarding spiking COVID-19 cases and renewed lockdowns in some states are a cause for concern. Orchid Island Capital is generally protected from defaults, but if mortgages defaults rise to the point that Fannie and Freddie struggle to insure them, it could cause counter-party risk (see 2008 Financial Crisis).
More importantly, the fear of this occurring could be enough to cause RMBS securities to decline on illiquidity and force Orchid into more margin calls. This is what occurred in March, and though the Federal Reserve came to the rescue, it was too late and Orchid (and others) had already been forced to realize significant losses.
Is Orchid’s Core Strategy Sound?
These are primarily short-term matters. Looking over the coming months, I see more reasons to take profits on Orchid Island Capital and avoid mortgage REITs as a whole. However, Orchid and its peers may still be a solid long-term investment that will pay high yields.
As of May 31st, when Orchid shared its monthly portfolio update, we can see that its portfolio as a whole has a weighted-average maturity of 336 months, or 28 years, with a weighted-average coupon of 3.7%. In order to finance its $3.4 billion portfolio, the company uses short-term repo financing, which generally matures every month and is subsequently rolled over. As of May 31st, these had a very low weighted-average repo rate of 28 basis points. This means the company is making a 3.5% spread with very low credit risk (due to agency insurance).
In my opinion, today’s very low residential mortgage rates are a risk, but they are actually high compared to 30-year Treasury bond yields as well as short-term borrowing rates. As you can see below, there has been a recent spike in the 30-year mortgage to 30-year Treasury spread, as well as other key spreads:
This does improve the company’s ability to generate cash flow in the short run. Of course, if the Fed pursues yield curve control, as it has recently become interested in doing, it could forcibly lower long-term rates and cause NIMs to become very thin. This would harm Orchid Island Capital’s liquidity but improve its book value.
However, the fact still remains that long-term bonds trade at a consistently lower yield than long-term mortgages despite agency insurance. As long as counterparty risk remains low (which it arguably is due to the government’s conservatorship of Fannie and Freddie), this gives Orchid a bit of a “free lunch”. It is also likely currently trading below its NAV, and will likely deliver strong and more stable dividends after 2020 has passed.
Overall, I like Orchid Island Capital in principle and believe that it is still a solid long-term value investment for those looking for high yields. That said, risks facing the firm are arguably as high as in April, but the stock is no longer heavily discounted. It is trading at a slight discount, but I do not currently believe this is enough to offset the risk of another slide in the RMBS market.
Further, the Federal Reserve may be less dovish going forward. As explained in-depth in “Ending Stimulus To End The Rally”, the Fed is running out of ammunition. Inflation expectations are on the rise and the U.S dollar is weakening, which limits its ability to create new money in the case of a liquidity crisis. To be frank, Orchid would likely have lost all of its value if it were not for QE. If this protection fades (even slightly), it could cause a liquidity spiral. For now, this is not likely, but it is enough of a risk to cause me to avoid mortgage REITs and Orchid Island Capital.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any 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.