Among the rate-sensitive, income-generating asset classes that are benefiting from the Federal Reserve’s reluctance to raise interest rates are mortgage real estate investment trusts (mREITs). The iShares Mortgage Real Estate Capped ETF (NYSEArca: REM) and the rival Market Vectors Mortgage REIT Income ETF (NYSEArca: MORT) are up an average of 2% this year.
The average trailing 12-month dividend yield on the two mREIT ETFs is 10.4%, underscoring why income investors previously embraced these funds and why these ETFs are vulnerable higher 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.
The recent bullishness displayed by mREITs has prompted some industry analysts to endorse the group, albeit on a tepid basis.
“Three companies in our coverage universe adjusted dividends downward for 2016, and we think that there will be no upward adjustments. Rather, we think there is a possibility that the trend will continue to be negative. In particular, low mortgage rates in March sent prepayment speeds up by about 5% over February factors. Increased prepayment speeds put pressure on net interest margins,” according to a Wunderlich Securities 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.