Higher yielding assets are benefiting from the Federal Reserve’s lower for longer policy on interest rates. That group includes the iShares Mortgage Real Estate Capped ETF (NYSEArca: REM) and the rival Market Vectors Mortgage REIT Income ETF (NYSEArca: MORT), which hold mortgage real estate investment trusts, or mREITs.
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.
“Rising interest rates are the main risk faced by mREITs, which essentially run leveraged portfolios of mortgage securities; that can boost the cost of their borrowings and thus reduce earnings. Rapid falls in mortgage rates also can have a negative impact as homeowners take advantage to refinance. That results in a rise in prepayments, which in turn have to reinvested at lower rates. Juggling these factors is at the core of managing mREITs, which which they’ve historically done with varying degrees of success,” reports Randall Forsyth for Barron’s.[related_stories]
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.
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.
MORT and REM, like other REIT assets become more attractive when yields on other fixed-income assets are pushed down. On the bright side for REM and its investors is the fact that the ETF’s dividend is expected to rise for the first time since 2014.
“The likelihood interest rates will remain low for an extended period is a ‘gamechanger’ for mortgage real estate investment trusts,” writes Wunderlich Securities analyst Merrill Ross. Even so, dividends may come under pressure for some mREITs and selectivity is needed in the group, she adds,” according to Barron’s.
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iShares Mortgage Real Estate Capped ETF
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