Mortgage REITs react to changing interest rates. Most mREITs obtain their lofty yields through leverage. They borrow money at one rate and buy mortgage paper (MBS) at a higher rate, and make money off the spread (or difference) between the two rates multiplied by the amount of leverage used. Because of leverage, mREITs usually have far more debt than their market value.
Rising interest rates will largely reduce spreads and values. This is not always the case, but usually is for several reasons, including that the rate increase usually affects borrowing costs more than it raises required MBS payments. Each mREIT has a proprietary allocation of fixed and adjustable rate (ARM) mortgage securities. Changes in rates will affect the value of these securities and the spreads these REITs make off of them. Other differences exist in portfolio composition, including agency backing or non-agency paper, and the rating/quality of non-agency paper, if any.
Many now believe that ARM paper will outperform fixed paper for these mREITs, because they find that the end of QE2 and U.S. debt limit concerns should cause the interest rate to increase. Depending on the terms and quality of such ARM paper, it may be able to quickly adjust to higher rates and without also causing the borrower to default. Below are the present ARM rates for seven large REITs AGNC, NLY, ANH, CMO, CIM, HTS, MFA that currently yield 12% or higher: (Click chart to expand)
Another concern is that the higher rates cause increased defaults by underwater and/or under-funded borrowers. This should primarily happen to ARMs, so while that paper may react better to an interest rate change on paper, it may go unpaid in reality. This is less of a concern to agency paper, where the government will pay or buy-out the paper. Where an agency buys a mortgage back from an mREIT, the managers must then go to market and replace it with as good of a mortgage. If a suitable replacement is not found then the spread or leverage will be reduced, so there is still some risk.
Interest rate increases can also cause default within fixed paper, where the rate changes reduce home values and cause already underwater or on the edge borrowers to throw in the towel, irrespective of their same low rate. Interest rate risk is likely to continue to cause volatility among these mREITs until some policy certainty, in whatever direction, is provided by the U.S. legislature. Disclosure: I am long CIM, NLY.
Disclaimer: This article should not be construed as personalized investment advice as it does not take into account your specific situation or objectives.