High-yielding, income-generating asset classes are benefiting this year as Treasury yields decline and the Federal Reserve puts off another interest rate increase. The group of beneficiaries includes exchange traded funds holding mortgage real estate investment trusts (mREITs), such as the iShares Mortgage Real Estate Capped ETF (NYSEArca: REM) and the Market Vectors Mortgage REIT Income ETF (NYSEArca: MORT).
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.
However, market observers see risks on the horizon for mREITs. 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.[related_stories]
“It all sounds pretty great, but gets a lot more complicated once you dig into the bewildering array of risks that affect the sector. Mortgage REITs make money by borrowing short-term to buy longer-term mortgage-backed securities (MBS) and, increasingly, other kinds of credit instruments. They are highly levered and get hurt when rates rise (because the value of their holdings falls, while funding costs increase) and also when rates fall (because more mortgages get prepaid, and hedging can backfire),” reports Amey Stone for Barron’s.