The iShares Mortgage Real Estate Capped ETF (NYSEArca: REM) and the rival Market Vectors Mortgage REIT Income ETF (NYSEArca: MORT) have been challenged this year by speculation that the Federal Reserve will soon raise interest rates, but that does not mean the entire thesis for owning high-yielding mortgage REITs (mREITs) is damaged.

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]

“Consider the case of Annaly Capital Management (NLY), the largest m-REIT by market cap. Annaly has spent virtually its entire history as a public company trading above its book value — as it should. As an investor, you should be willing to pay a modest premium for Annaly’s management expertise and its low cost of capital,” writes Charles Sizemore of Sizemore Insights. “But in 2012, something changed. Investors became less and less willing to pay up for Annaly’s shares, and they pushed the price into discount territory. That discount has been widening ever since, and today Annaly trades for just 80 cents on the dollar.”

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. Annaly is component in both ETFs.

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.

Market Vectors Mortgage REIT Income 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.