After tumbling last year in anticipation of higher interest rates, the iShares Mortgage Real Estate Capped ETF (NYSEArca: REM) and the rival Market Vectors Mortgage REIT Income ETF (NYSEArca: MORT) are struggling to start 2016 as the yield curve is flattening.
The two mortgage real estate investment trust exchange traded funds are down an average of 9.5% year-to-date. 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.
“Mortgage real estate investment trusts (mREITs) were falling Tuesday as the yield curve flattened. The spread between the benchmark 10-year note and the two-year note has compressed, making investors wonder if mREIT earnings are destined to fall, putting high dividends at risk,” reports Amey Stone for 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.
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.
“MREITs with lower leverage – namely NLY and AGNC – possess the ability to overpower the challenge posed by a flatter yield curve and a potentially lower net interest spread (NIS). In fact, NLY and AGNC should be able to grow earnings despite 25bp lower NIS and still run with leverage under 8 turns,” according to a Nomura note posted by Barron’s.
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.