Enticing Yields And Risks With Mortgage REIT ETFs

Among the asset classes seen as vulnerable to rising rates are high-yielding mortgage real estate investment trusts, or mREITs, including those held by exchange-traded funds such as the iShares Mortgage Real Estate Capped ETF (iShares FTSE NAREIT Mortg.REITIn Fd(ETF) REM) and the Market Vectors Mortgage REIT Income ETF (Market Vectors ETF Trust MORT).

During the go-go days of the Federal Reserve's quantitative easing program, MORT and REM were favored destinations by income investors. These days, an average trailing 12-month dividend yield on the ETFs of about 11 percent tempts, but the sensitivity of MORT and REM to rising rates cannot be overlooked.

“Mortgage REITs have exhibited a negative correlation to interest rates changes, especially if the yield curve flattens. Many agencies use leverage to capitalize on the arbitrage spread between short- and long-term interest rates, so companies can still make money in a rising rate environment, as long as long-term rates rise faster than the short-term rate or if the yield curve steepens,” according to ETF Trends.

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Over the past year, MORT and REM are down an average of 16.6 percent, but although 10-year Treasury yields are off 11.1 percent over the past month, MORT and REM are lower by an average of 9.8 percent. The two mREIT ETFs each hit 52-week lows last Friday.

Recent Performance

“Interest rates and sentiment regarding rate movements historically have had a major impact on mortgage REITs (investor uncertainty about interest rates prompted mortgage REITs' 2013 sell-off),” said Morningstar in a recent note.

“At the same time, rising rates are not necessarily all bad for mortgage REITs. Higher short-term rates certainly increase funding costs, but the effect could be mitigated somewhat if long-term rates rise even faster, resulting in a steeper yield curve and a greater spread. (While many mortgage REITs hold fixed-rate residential mortgages and mortgage-backed securities, some hold variable-rate commercial property loans. As such, REM is exposed both to fixed-rate and floating-rate securities.)”

REM: Allocations And Holdings

The $745.3 million REM holds 37 stocks, though a substantial portion of the ETF's weight is allocated to Annaly Capital Management, Inc. NLY and American Capital Agency Corp. AGNC. Those stocks combine for 27.3 percent of the ETF's weight. Those two stocks combine for over 24 percent of MORT's weight.

Rates And mREITs

Rising short-term interest rates are particularly problematic for mREITs because these companies depend on short-term loans. However, some analysts see favorable risk/reward with mREITs because some of the names held by MORT and REM now trade at steep discounts to book value. Industry-wide, mREITs trade at a 25 percent discount to book value, according to Credit Suisse.

“Mortgage REITs' future is uncertain. The Fed no longer is a regular buyer of MBS, and commercial banks largely have fulfilled their government-imposed requirements to add high-quality assets to their balance sheets, reducing MBS demand and causing higher rates for MBS borrowers. Several factors could boost MBS supply: If mortgage credit loosens, if the housing market improves meaningfully, if nonagency-to-agency refinancing goes up, or if banks revert to securitizing more loans instead of placing them on their balance sheets. While a greater MBS supply could have an impact on spreads, the MBS marketplace is far more stable now than it was in the past,” said Morningstar.