Real estate stocks have taken a beating in recent months as rising interest rates derail the momentum of this beloved income sector. Yet despite the dip in traditional housing and commercial REITs, one high yield segment of the market is still seeing surging prices.
Mortgage REITs (or mREITs) have largely ignored the trend in Treasury bonds and instead focused on the continued strength in overall credit conditions. This has translated into new all-time highs for the small group of exchange-traded funds that track these investments.
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To review, mortgage REITs are an alternative income-generating vehicle versus traditional stocks or bonds. These companies borrow short-term money at cheap interest rates and use it to buy long-term mortgage-related debt. This enables them to pocket the spread on interest rates and distribute the majority of earnings to shareholders as income. They also use embedded leverage to increase their capital at risk.
The largest fund by a wide margin in this arena is the iShares Mortgage Real Estate Capped ETF (NYSEARCA:REM), which as $1.2 billion in total assets. This ETF is home to a diverse basket of 36 mREITs with top holdings in well-known names such as Annaly Capital Management, Inc. (NYSE:NLY) and AGNC Investment Corp (NASDAQ:AGNC). The index is market cap weighted, which gives the largest share of assets to the biggest companies. As such, NLY and AGNC make up over 28% of the total asset allocation.
REM is one of a very select group of ETFs that offers a yield north of 9%. For comparison purposes, junk bond indexes currently yield 6%, investment grade bonds 3%, and Treasuries in the low 2% range. During dips in price, REM has even been known to offer investors an income stream that touches double digits. That’s an extremely wide spread to Treasuries and other high quality debt instruments. It’s also worth noting that income is paid quarterly to investors in these funds, rather than monthly as many bond funds do.
The thing I always caution investors about when they get googly-eyed over yield is to remember that there is no free lunch in the income world. The larger the income stream, the greater risk of volatility and capital deprecation. That is why these tools should be used in moderation and with the understanding that they are at the upper end of the risk scale.
For comparison purposes, REM has recently diverged from a traditional REIT portfolio like you would find in the Vanguard REIT Index Fund (NYSEARCA:VNQ). The chart below shows how these two funds were maintaining a fair degree of correlation prior to the jump higher in rates.
Historically these mREITs can be sensitive to changes in both interest rates and credit conditions. Although in today’s market they appear more fixated in the strength of stocks and high yield bonds. Any meaningful contraction in those areas will likely result in a concomitant pullback in REM as well.
For those that like a menu of options at their disposal, the VanEck Vectors Mortgage REIT Income ETF (NYSEARCA:MORT) is a direct competitor to REM. This fund own a concentrated mix of 26 mREITs with a greater percentage of assets spread to the smaller holdings. MORT also charges a moderated expense ratio of 0.41% versus 0.48% in REM. This fund currently has over $100 million in assets and a 30-day SEC yield near 10%.
Lastly, for those who have an extremely high risk tolerance level and don’t like to sleep much at night, there are exchange-traded notes in this field with a built-in leverage component. The ETRACS Monthly Pay 2xLeveraged Mortgage REIT ETN (NYSEARCA:MORL) tracks an index of mREITs with a 2x daily price magnification. This fund has a current listed yield of 20.49% and income is paid monthly to shareholders.
Keep in mind that leverage on leverage is a volatile recipe with high costs and potentially unpredictable tracking patterns over long periods of time. Funds of this nature should be very carefully examined and used with great caution.
The Bottom Line
It’s always worth noting where the areas of strength or weakness are in the market and mREITs have certainly held a resilient path despite many obstacles. I don’t currently own exposure to this segment of the market for my clients and would prefer to evaluate it again on a drop rather than buying up here near the highs. These types of funds would likely be appropriate as a small tactical play in the context of a diversified income portfolio with the inherent expectation of above-average yield and price volatility.
Note: This article is written by David Fabian and was originally published on the FMD Capital Management blog. FMD Capital Management is a fee-only investment advisor which provides daily updates on ETFs, portfolio strategies, and market insights. Contact them for a free portfolio review.
