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.
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.
“With some pressure still expected on core earnings and thus dividends, we do not believe that valuations will markedly improve for the group as a whole. At the same time, share repurchases and potential M&A activity could provide a bit of price support, and we think that dividends continue to make these equities worth owning in a diversified, income-oriented portfolio,” adds Wunderlich in the note posted by Barron’s.
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