Mortgage REIT funds such as iShares' REM and individual mortgage REITs have very high yields, but these are accompanied by high volatility. Do mREITs have a meaningful place in income portfolios or is the risk just too high?

Goldman Sachs recently warned investors that two large mortgage REITs (mREITs), AGNC and NLY, are likely to be bad bets because of their exposure to rising rates. As the article from Barron's (linked above) notes, however, this warning would have really come in handy a year ago. Most mortgage REITs have taken a beating as Treasury yields have risen in anticipation of the Fed's eventual reduction in Quantitative Easing (QE). AGNC is down 22% over the past year (including income distributions) and its price is 40% below its 52-week high. Annaly has suffered a similar decline, albeit not quite as extreme. AGNC yields 22.6% and NLY yields 16.94%.

The basic narrative is obvious. mREITs are very negatively impacted by rising rates and the Fed must eventually allow rates to rise, which will drive down mREIT distributions because their costs of borrowing will rise. The correlation between the monthly total return on AGNC and the 10-year Treasury yield is -30% over the past five years. This same metric is -41% for NLY. These negative correlations and high volatilities mean that these mREITs tend to decline hard with rising bond yields. But does this all mean that mREITs are too risky to be worth an allocation in an income portfolio?

NLY and AGNC are the two largest holdings of the iShares Mortgage REIT ETF (NYSEARCA:REM), making up 28% of the total portfolio. REM is down about 7% over the past twelve months and currently yields 15.8%. REM's 3-year returns are low but positive at 2.5% per year. The five-year track record is better, with annualized returns of 7.8%. Any recent historical period is suspect as a guide of things to come for this asset class, however.

Are Mortgage REITs unsafe at any yield? Surely, there is some price and yield at which mREITs are worth at least a modest position. If so, how would we determine this? I have come up with an interesting way to explore this issue. I don't know what the Fed is going to do next and, subsequently, the risk in mREITs that is associated with interest rates is hard to price. There are, however, assets that have positive correlations to rising rates. In general, equities fare well in rising rate environments, even as bonds suffer. Small cap stocks, in particular, tend to do well when rates rise. See here for more support of this point. My question is how much yield we could retain if we combine mREITs with small-cap stocks to end up with an interest-rate neutral portfolio. If we can create portfolios that have both attractive yields and that are rate neutral, perhaps mREITs have been beaten down too far and suggest a position. As my representative for small cap stocks I will use IWM, the iShares Russell 2000 ETF. IWM's returns have a +34% correlation to 10-year Treasury yields over the past five years.

Consider the following. REM has a -13% correlation to the 10-year Treasury yield over the past five years. A portfolio that is 50% REM and 50% IWM (Russell 2000) has an 8.7% yield and a +14.9% correlation to 10-year Treasury yield. Now, this is not a low risk portfolio, with trailing 5-year volatility of 16.8% as compared to 15.9% for REM and 15.8% for the S&P 500. So let's next look at variations with lower risk.

A portfolio that is 45% REM / 45% IWM / 10% BIL has a yield of 7.8%, a trailing 5-year volatility of 15.1%, and +14.8% correlation to 10-year Treasury yield.

A portfolio that is 33% REM / 33% IWM / 33% BIL has a yield of 5.7%, a trailing 5-year volatility of 11.1% and +14.8% correlation to 10-year Treasury yield.

BIL is simply a proxy for cash. To put these results in some context, the best portfolio of utilities that I have recently been able to assemble has a 5.3% yield, 0% correlation to 10-year Treasury yield, and trailing five-year annual volatility of 13.5%. On this basis, the yield from simply pairing small cap stocks with mortgage REITs (and a cash equivalent, BIL) looks pretty good (see the 33% REM/33% IWM/33% BIL case) with 5.7% yield, lower volatility, and a more positive correlation to rising yield. Obviously, in real life you would not compare these to each other but rather analyze their complementary effects (if any) in a portfolio. This step is beyond the scope of what I am discussing here, however.

Small cap stocks are the momentum bet and mREITs have taken a beating as a result of rate fears. My point is that by combining these two asset classes we can make a rational judgment about the yields available from mREITs without taking on huge amounts of interest rate risk. Small cap stocks combined with REITs make an interesting sub-portfolio and, in fact, make the current yields from REM look quite attractive on a total portfolio basis.

My central point here is that rather than trying to bet on the direction of interest rates, investors will do better to find allocations of mREITs with other asset classes that are fairly interest rate neutral yet still provide some of the massive yield offered by mREITs. While interest rates must eventually rise, the question is when. I am not confident enough to take the tactical bet one way or the other. My analysis suggests, however, that you can offset the interest rate exposure in mREITs using small cap stocks and still have an attractive risk-adjusted yield for income investors on the higher yield / higher risk end of the risk-yield frontier. I cannot emphasize this last point enough--this is a high yield / high-risk strategy. Both IWM and REM tanked in 2008, for example. REM lost 43% and IWM dropped 34%. The 33% REM / 33% IWM / 33% BIL portfolio would have lost 25% in 2008. This can be compared to the 30% loss for IDU in 2008. Not terrible on a relative basis, but a big drop.

**Disclosure: **I am long REM, AGNC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.