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The Marvelous Mortgage REIT ETFs

ETF Professor

Mortgage real estate investment trusts, also known as mREITs, are an income-generating asset class that has been made more accessible to a broader swath of investors thanks to exchange traded funds.

The largest mREIT ETFs and the underlying securities themselves are high-yield assets, making them sensitive to changes in interest rates, but amid a more sanguine rate outlook, mREIT ETFs could be worth considering again.

What Happened

The iShares Mortgage Real Estate ETF (CBOE: REM) and the VanEck Vectors Mortgage REIT Income ETF (NYSE: MORT) are the leaders among mREIT ETFs with $1.24 billion and $161.60 million, respectively, in assets under management. REM is up about 9 percent this year.

“Simply, an mREIT is a leveraged investment on the shape of the yield curve – that is, they borrow short and invest long,” said Rareview Macro founder Neil Azous in a recent note. “Because the positive spread is 1.25-1.50%, even with the inverted/flat yield curve currently, using ~7 times average leverage, the carry is upwards of 10%. When the yield curve steepens, the net spread that mREIT’s earn increases.”

Why It's Important

REM and MORT have an average 30-day SEC yield of 9.36 percent, so mREITs are used as hedges against rising rates, it's not surprising MORT and REM lost an average of 3.75 percent in 2018 when the Federal Reserve raised interest rates four times.

This year, however, it's possible the Fed doesn't raise rates at all, potentially increasing the allure of mREITs and the aforementioned ETFs.

“Firstly, when mREIT’s recognize that the Federal Reserve hiking cycle is over and the next move is an interest rate cut, they will likely lift portions of their interest rate hedges and run a positive duration gap – meaning they will be net long mortgage securities at ~7 times leverage,” said Azous. “This will allow them to potentially reap the full potential of lower interest rates.”

What's Next

Should it become apparent that the Fed is considering cutting rates, MORT and REM likely benefit under that scenario, too.

“Secondly, when the Federal Reserve begins lowering interest rates, an mREIT’s cost of leverage will reset lower, which increases its net income spread,” said Azous. “Over time, this will likely lead to a rise in dividends and contribute to an increase in book values. Collectively, we believe that the potential for mREIT’s to generate a high amount of total return over the next year is significant. For a product with a historical volatility of ~13, the risk-adjusted return potential is one of the best in the public markets.”

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