Mortgage REIT ETFs Losing Appeal

Mortgage REIT ETFs were payout darlings in 2012, serving up hefty income and good performance to investors who owned them, as they looked to the space for alternative income in a low-rate environment. Now, it seems those days might very well be behind them.

Since the beginning of the year, mortgage REIT ETFs have had a tough time getting off the ground, as the companies they hold face declining book value amid rising interest rates. Mortgage REITs essentially borrow money for mortgages, and their revenues consist of interest income earned on the mortgages they hold. Since they are—at their heart—a spread play, that income is very sensitive to fluctuations in interest rates, as IndexUniverse ETF analyst Paul Baiocchi pointed out.

The higher-rate environment—10-year Treasury note yields have jumped nearly 100 basis points so far this year—has hurt the mortgages that are on the books of these REITs because, at least in theory, the book value of REITs is inversely correlated to interest rates.

Those higher rates have also impacted these ETFs’ dividend payouts. These payouts come from their respective funds for operation, or FFO, and if mortgage REITs are increasingly less profitable as a result of higher rates—and therefore tighter spreads—their ability to pay out dividends could be further challenged as well.

Unfortunately, the outlook for these REITs and the ETFs that invest in them doesn’t seem particularly bright going forward given that rates are likely to go higher. The Federal Reserve is expected this year to unwind its massive monthly bond purchases that have kept long-term interest rates at historically low levels for much of the past five years.

Moody’s Analytics, for instance, said in its latest macro outlook that it expects 10-year rates to climb to 3.5 percent by year-end 2014, and 4.5 percent by 2015. That’s a sizable jump considering these notes were yielding as little as 1.6 percent earlier this year.

One of the largest mortgage REIT ETFs is the iShares Mortgage Real Estate Capped ETF (REM), with nearly $1 billion in assets. The fund, which competes with the likes of Market Vectors Mortgage REITs ETF (MORT), comprises a similar handful of names that are also found in MORT and in relatively high concentration—about two-thirds of the fund is allocated to the top 10 holdings.

That’s a reflection of a segment in the market that is populated by only a few companies that survived the real estate crisis, offering little diversification for these ETFs, Todd Rosenbluth, director of ETF research for S'P Capital IQ, told IndexUniverse.

Names like Annaly Capital Management, American Capital Agency and Starwood Property Trust are some of the big players in residential and commercial mortgage REITs, and many of them have recently seen their stock prices slide amid declining book values.

“If mortgage REITs are less profitable as a result of higher rates, their ability to pay dividends could be more challenged, which could reduce the appeal of these ETFs for income,” said Rosenbluth.

“In a low-interest-rate environment, mortgage REIT ETFs made sense and did well, partly due to their dividends, but they have struggled this year in a rising rate environment,” he added. “If rates continue to rise, it will hurt the appeal of mortgage REIT ETFs.”

REM costs 8 basis points more in annual fees at 0.48 percent expense ratio when compared with MORT’s price tag, but some of that cost comes out in the wash because REM trades at just a 1 penny bid/ask spread, while MORT’s bid/ask spread is currently 7 cents. MORT has just $182 in AUM.

Still, from a performance perspective, REM has now slid 18 percent in the past three months alone, putting year-to-date losses at around 4 percent, according to data compiled by IndexUniverse. However, the fund’s trailing dividend yield is still clocking in at a strong 15 percent.

In a similar vein, MORT, has bled 17.3 percent of its value in the past three months, putting it some 2.1 percent in the red year-to-date. Its indicative dividend yield is currently 11.7 percent, according to IndexUniverse data.

Another ETF in this segment, according to IndexUniverse’s ETF Analytics, is the SPDR S'P Mortgage Finance ETF (KME), a fund that expands well beyond mortgage REITs in a strategy that has worked well so far to buffer its performance from the impact of rising rates.

Rosenbluth would argue that KME is not really a mortgage REIT ETF—half of its assets are in property and casualty insurance companies, and it also invests in homebuilding names. That diversification puts its overall performance more in line with traditional financial services ETFs than mortgage REITs funds.

Still, KME is another fund in that segment, offering up exposure to some pure mortgage players, but investors have so far been slow to embrace the strategy as a viable allocation to mortgage REITs despite what’s been a stellar performance relative to REM and MORT.

KME is up 22 percent year-to-date after having slid only 0.4 percent in the past three months since rates started to rise. The $7.8 million fund’s indicative dividend yield is currently 2.1 percent, and its bid/ask spread is an “extremely wide” 25 cents, which really trims its pricing advantage tied to its 0.35 percent expense ratio, Rosenbluth noted.

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