Exchange traded funds holding high-yield mortgage real estate investment trusts (mREITs) got some welcomed relief last week when the Federal Reserve opted to maintain its zero interest rate policy.
That does not mean the iShares Mortgage Real Estate Capped ETF (NYSEArca: REM) and the rival Market Vectors Mortgage REIT Income ETF (NYSEArca: MORT) are out of the woods. In an updated economic forecast, 13 of 17 Fed policymakers believe there will be a rate hike sometime this year, whereas 15 Fed officials predicted a rate hike this year back in June. Additionally, the forecast diminished the number of rate hikes to reflect expectations of just one quarter-point raise, compared to two expected hikes at the June meeting.
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]
If the Fed decides to hike rates, mREITs will be pressured. Mortgage REITs rely on short-term loans, so costs could rise if short-term rates suddenly spike. However, the negative effect of higher short-term rates could be somewhat offset by quickly rising long-term rates as mREITs benefit from a steeper yield curve and arbitrage the wider spread.
MORT and REM are down an average of 6.5% over the past six months and have been dragged lower by their small-cap constituents.
“It is unclear whether the outperformance of large-cap mREITs vs. their small-cap brethren will persist into the future. The constant jitters and palpitations over a potential rate hike in 2015 may have unfairly punished small-cap mREITs, which are probably deemed to be more risky and volatile compared to their larger peers. However, this is just my rough guess, and more knowledgeable mREIT investors may have a better answer to this conundrum,” according to a post on Seeking Alpha.
iShares Mortgage Real Estate Capped ETF
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.