When income investors were not fretting about interest rate hikes by the Federal Reserve, the iShares Mortgage Real Estate Capped ETF (NYSEArca: REM) and the Market Vectors Mortgage REIT Income ETF (NYSEArca: MORT) were beloved income ideas.
However, speculation that the Fed will boost borrowing costs this year has punished plenty of income-generating asset classes with mortgage REITs (mREITs) being among the most vulnerable. The improved labor market helps support the Fed’s plan for raising short-term interest rates this year, possibly in September, as some officials have hinted at.
However, a higher interest rate environment means lower profits for mortgage-backed REITs. The mREITs invest in financial firms that borrow at short-term rates and buy long-term mortgage securities, profiting on the spread, reports Eric Balchunas for Bloomberg.
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. [mREIT Opportunity]
When Treasury yields surged two years ago, MORT posted a gain of just 1.1% while REM slid 2.7%, underscoring the inverse relationship these ETFs have to Treasury yields. Conventional wisdom dictates that higher interest rates diminish the chances that homeowners will refinance their mortgage rates. Additionally, many mortgage REITs did not anticipate the sharp spike in interest rates and the result was a rash of dividend cuts from REM and MORT holdings.