Interest Rates Are Already Hurting Mortgage REIT ETFs
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).
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.
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.