The past year has not been kind to exchange traded funds holding mortgage real estate investment trusts, or mREITs. Over that period, the iShares Mortgage Real Estate Capped ETF (NYSEArca: REM) and the rival Market Vectors Mortgage REIT Income ETF (NYSEArca: MORT) are down an average of 17%.
MORT and REM currently sport an average trailing 12-month dividend yield of about 13%, so it is understandable that these ETFs tempt yield seekers. However, it is widely believed that these ETFs and their holdings are vulnerable to rising interest rates.
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]
Though mREITs’ negative relationship to interest rates is widely known, that is not preventing some analysts from making bullish calls on the group.
“The economic return performance has been weak in 2015 and the outlook for 2016 remains challenging. However, with the sector already trading at a 25% discount to book, we see many of the risks as already being reflected in the valuation. As a result, we feel the mREITs present an attractive risk/reward. That being said, we don’t see any clear catalysts to drive increased valuation and expect the majority of the return to come from the 14.7% dividend yield,” according to a Credit Suisse note posted by Amey Stone of Barron’s.
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.
“On average, the sector will have a 3-4 basis point contraction (with a wide dispersion) in the net interest margin from each 25 basis point rate increase; Ares Commercial Real Estate (ACRE) and STWD are the best positioned for potential increases in rates based on this metric,” said Credit Suisse in the note posted by Barron’s.
Market Vectors Mortgage REIT Income ETF
