Few income-generating asset classes are as sensitive to fluctuations in interest rates as are mortgage real estate investment trusts (mREITs), so it is not surprising that with all the talk of the Federal Reserve raising interest rates this year that the iShares Mortgage Real Estate Capped ETF (NYSEArca: REM) and the Market Vectors Mortgage REIT Income ETF (NYSEArca: MORT) have struggled.
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]
Now, traders are wagering that the Fed is backed into a corner and cannot raise interest rates in 2015. If that proves accurate, it could breathe new life into ETFs like MORT and REM.
“Like many financial companies that borrow short-term and lend or invest long-term, mREITs can struggle during rising-rate environments because their funding costs rise faster than the yield on the assets they hold. Conversely, they tend to rally when investors believe the Fed will start cutting rates. A flattening yield curve –like Friday’s—where short-term rates rise and long-term rates fall, also reduces earnings prospects. MREITs attempt to hedge out near-term rate risk, but they don’t always get it right,” reports Amey Stone for Barron’s.