Interest Rates Are Already Hurting Mortgage REIT ETFs

And this one in particular

What's Happening

There've been shiny, happy returns on offer from investing in real-estate investment trusts.

Source: Photograph by Scott Eells/Bloomberg

R.E.M. is the name of an alternative rock band that formed in the early 1980s.

REM is the name of an exchange-traded fund that began trading in 2007.

The iShares Mortgage Real Estate Capped ETF, or REM, has quietly amassed more than $1 billion in assets since 2010 as yield-thirsty investors have been lured in by the fund's juicy 14 percent yield. For perspective, that’s more than three times the yield of the mega-popular $26 billion Vanguard REIT ETF (VNQ). 

Source: Bloomberg

But REM is not your grandfather's REIT ETF. REM doesn’t own companies that own properties, but rather it invests in financial firms that borrow at short-term rates and then buy long-term mortgage securities, profiting from — and passing on as income — the difference. Thus, the 14 percent yield.

These companies’ margins are sensitive to the shape of the yield curve. They love a steep yield curve — where short-term rates are very low and longer-term rates much higher — since it means a bigger "spread" that they can pocket. The curve has been steep for years now thanks to the Fed’s monetary policy. But as the probability of a Fed rate hike goes up, the yield curve has begun to flatten, with short-term rates rising faster than long-term rates. The chart below shows that as the two-year U.S. Treasury yield, the shorter end of the Treasury curve, has been rising, REM’s price has been falling.

Source: Bloomberg

While the yield curve has already been flattening in anticipation of a potential Fed rate hike, the trend could intensify once the central bank pulls the trigger on the first rate hike in almost a decade.

That could spell even more trouble for REM’s performance and that juicy 14 percent yield.

We got a peek into REM’s sensitivity to rising rates when it fell 9 percent in June as the two-year yield rose 6 percent. It also lost 12 percent in May 2013 when the two-year rose 41 percent. And now this summer, REM is starting to show cracks as it's down 5 percent since Memorial Day, while bleeding $80 million in cash.

REM is not the only way investors have been getting their yield on with mortgage REITs. The Market Vectors Mortgage REIT Income ETF (MORT) has gathered $112 million in assets with its 10.8 percent yield. And as with any popular ETF category, there's always a leveraged option putting up some insane numbers. In this case, it's the ETRACS Monthly Pay 2xLeveraged Mortgage REIT ETN (MORL), which is yielding 27 percent — the most out of all the 1,762 ETFs in the entire exchange-traded universe. MORL is, after all, a leveraged ETN tracking leveraged companies. Despite the additional risk, it has $320 million in assets, which is sizable for such an obscure product.

While REM is a unique ETF, in the end it's just another example of an investment popularized by income-starved investors. The unfortunate downside, of course, is that when rates rise — especially short-term rates in this case — everybody hurts.

Eric Balchunas is an exchange-traded-fund analyst at Bloomberg. This piece was edited by Bloomberg News.

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