Orchid Island Capital, Inc. — Q3 2018 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2018. Orchid is an externally managed mortgage REIT investing primarily in agency residential mortgage-backed securities (RMBS), funded largely through short-term repurchase agreements. Dollar amounts below are in millions unless noted.
Key financial results and position
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Interest income | $39.1 | $39.0 | $117.6 | $105.9 |
| Interest expense | $18.9 | $12.6 | $50.6 | $28.1 |
| Net interest income | $20.2 | $26.3 | $67.0 | $77.7 |
| Net portfolio income (loss) | $0.01 | $18.1 | $(9.0) | $16.2 |
| Net income (loss) | $(3.0) | $15.2 | $(18.0) | $8.0 |
| Net income (loss) per share | $(0.06) | $0.33 | $(0.34) | $0.21 |
| Dividends declared per share | $0.25 | $0.42 | $0.83 | $1.26 |
- Portfolio losses: Nine-month RMBS realized and unrealized losses totaled $145.5 million; derivative gains were $69.5 million, leaving net RMBS and derivative losses of $75.9 million. Q3 net RMBS and derivative losses were $20.2 million.
- Margins: Nine-month GAAP net interest spread was 2.32%, versus 2.87% a year earlier; the company’s non-GAAP economic spread was 2.18%, versus 2.42%. Q3 GAAP spread was 2.11%, versus 2.62%, while economic spread was 2.14%, versus 2.19%.
- Balance sheet at September 30: RMBS fair value was $3,514.0 million; cash and cash equivalents were $164.4 million, with another $30.9 million restricted. Repurchase borrowings were $3,321.8 million, at a 2.30% weighted-average borrowing rate. Stockholders’ equity was $393.3 million, down from $462.2 million at December 31, 2017.
- Funding and liquidity: Repo debt was approximately 8.4 times period-end equity. Repo maturities ranged from 1 to 74 days, with a 37-day weighted average. The company reported $15.2 million of unpledged securities and said it had met all margin calls. It reported $95.1 million of operating cash flow for the nine months and a $51.4 million net decrease in cash, cash equivalents and restricted cash.
- Portfolio and hedging: RMBS effective duration was 3.340 at September 30, compared with 2.989 at year-end. The portfolio was entirely agency-backed; 96.1% was pass-through securities and 3.9% structured RMBS. The company reported $69.5 million of nine-month derivative gains, which helped offset RMBS losses.
Material changes versus comparable periods
- Nine-month results shifted from $8.0 million net income to an $18.0 million net loss. Q3 shifted from $15.2 million net income to a $3.0 million net loss.
- Nine-month interest income rose $11.7 million, but interest expense increased $22.5 million; net interest income consequently fell $10.8 million. Management attributed higher interest income to a larger average portfolio and higher yields, and higher interest expense to increased borrowing costs and average borrowings.
- Average asset yield increased to 4.25% from 4.04% for the nine-month period, while average GAAP funding cost rose to 1.93% from 1.17%. Nine-month economic funding cost increased to 2.07% from 1.62%.
- RMBS losses increased substantially year over year, while derivative results improved from a $29.3 million loss to a $69.5 million gain. Period-end RMBS and repo balances were lower than at December 31, 2017; management said the portfolio was deleveraged during Q3.
- Dividends declared fell to $0.83 per share for the first nine months from $1.26 a year earlier. A further $0.08 per share dividend was declared October 17 for payment November 9; it was not recorded in the September 30 financial statements.
Outlook, commentary and risks
- Management gave no specific earnings or dividend guidance. It described a strong U.S. economy, rising interest rates and expectations of further Federal Reserve rate increases. The Fed’s RMBS reinvestment run-off reached a $20 billion monthly cap in October 2018, reducing a significant source of market demand.
- Management reported that Agency RMBS had underperformed in early October as rates moved higher and investors sold securities amid concerns about duration extension (“convexity-related selling”). It identified the balance of supply and demand, market spreads, and the loss of Fed demand as important drivers of future performance.
- Key risks include rising short-term funding costs, RMBS price and spread declines, extension and prepayment risk, derivative hedge mismatch, repo renewal and haircut changes, margin calls, and counterparty default. Repo agreements are short-term and can generally be terminated at the master-agreement level; the company noted that collateral values and borrowing capacity can change.
- For a modeled instantaneous +200 basis-point rate shock at September 30, the filing estimated a portfolio-value decline of 0.96% and a book-value decline of 8.57%. Management cautioned that the estimates rely on assumptions and models, assume a static portfolio, and may differ materially from actual outcomes.
- The company reported no material pending legal proceedings, no material changes to previously disclosed risk factors, no material capital-expenditure commitments, and no off-balance-sheet arrangements. Disclosure controls were assessed as effective.
Important facts for investors to verify
- Whether reported derivative gains continue to offset RMBS valuation losses, and how much of the result reflects realized versus unrealized marks.
- Whether funding costs continue to rise faster than asset yields, and how that affects GAAP and economic net interest spreads.
- Repo renewal terms, collateral haircuts, available liquidity and margin-call exposure given the short average repo maturity and high leverage.
- RMBS valuation, spread and duration sensitivity under changing rates, prepayments and reduced Federal Reserve demand.
- Dividend sustainability and the relationship between distributions, REIT taxable income, GAAP losses and book value.