No Free Lunch: Tempting Yields And Lots of Rate Risk With These ETFs

For all the talk of the Federal Reserve raising interest rates, which could happen as soon as next month, an important point as it pertains to an array of income-generating, rate-sensitive asset classes is sometimes overlooked. Even when the Fed does start hiking rates, it is going to take a while before rates resemble “normal,” whatever “normal” may be after years of a near zero interest rate policy (ZIRP).

Still, even the specter of modest increases in borrowing costs has weighed on some popular income-related exchange traded funds this year. ETFs holding real estate investment trusts (REITs) have endured significant redemptions as investors have fretted over how changes in Fed policy will affect this once beloved income destination. 

Mortgage REIT, or mREIT ETFs are facing issues of their own. The iShares Mortgage Real Estate Capped ETF REM and the Market Vectors Mortgage REIT Income ETF MORT are the well-known funds in the mREIT ETF space and thanks to the Fed's ZIRP, these ETFs have garnered notable followings for one primary reason: Jaw-dropping yields.

The $1.06 billion REM has a trailing 12-month yield of almost 14 percent while the $113.7 million MORT has a 30-day SEC yield of nearly 15.3 percent, according to Market Vectors data.

While those yields are far higher than what investors will find on traditional REIT ETFs, mREIT funds sensitive to interest rate and regulatory changes. History proves as much.

“We got a peek into REM’s sensitivity to rising rates when it fell 9 percent in June as the two-year yield rose 6 percent. It also lost 12 percent in May 2013 when the two-year rose 41 percent. And now this summer, REM is starting to show cracks as it's down 5 percent since Memorial Day, while bleeding $80 million in cash,” reports Eric Balchunas for Bloomberg. 

And there is this: Ten-year Treasury yields have climbed 11.7 percent over the past six months, a move that has contributed to an average loss of 8.6 percent for MORT and REM over the same period. Interestingly, the outflows from mREIT ETFs this year have not been overwhelming. In fact, MORT has added nearly $8.2 million in new assets while REM has lost just $42.2 million, an outflow total that is modest when compared to some of the big-name traditional REIT ETFs.

The problem for MORT and REM is that one of the cornerstones of mREITs' income-generating capabilities is low short-term interest rates, the very rates likely to rise when the Fed shifts course. So when short-term rates rise, MORT and REM could be pinched leaving income investors to feel the pain.