While the Federal Reserve appears set to raise interest rates later this month, higher yielding assets have come under some pressure.
That group includes the iShares Mortgage Real Estate Capped ETF (NYSEArca: REM) and the rival VanEck 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.
However, income investors should not be hasty in abandoning rate-sensitive mREITs even if the Fed moves forward with boosting borrowing costs.
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.
“REM is one of a very select group of ETFs that offers a yield north of 9%. For comparison purposes, junk bond indices currently yield 6%, investment grade bonds 3%, and Treasuries in the low 2% range. REM currently offers a double-digit yield — abnormal, as it typically only achieves this on price dips. That’s also an extremely wide spread to Treasuries and other high-quality debt instruments,” according to InvestorPlace.
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.
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“MORT owns a concentrated mix of 26 mREITs with a greater percentage of assets spread to the smaller holdings. MORT also charges a moderate expense ratio,” adds InvestorPlace.