REM Offers A Dividend Yield Of 13.89%, But Is It Safe?

| About: iShares Mortgage (REM)

Summary

The portfolio is heavily concentrated on a few mortgage REITs with over 30% in the top 3 holdings.

With an expense ratio of 0.48%, it would be nice to see some careful management.

The share count for REM can be used as a proxy for the flow of new investors into the sector.

Strong demand for REM drives strong share prices and makes it easier to produce new shares.

The interest rate curve has been relatively flat over the quarter with a slight move towards lower rates.

The iShares Mortgage Real Estate Capped ETF (NYSEARCA:REM) is offering a beastly dividend yield, but the fund is delivering that massive yield through heavy investments in mREITs. Investors that aren't familiar with the mREIT industry need learn the risk factors that are influencing REM.

The biggest risk for investors in REM is that the value of the underlying holdings, the mREITs, could change quite substantially. I wouldn't mind seeing the ETF try to weed out a few of the most expensive mREITs. Unfortunately, that would require active management. For an expense ratio of 0.48%, I'd like to think some active work was justified.

Holdings

The following chart breaks down the holdings:

Click to enlarge

Annaly Capital Management (NYSE:NLY) is fairly huge at 16.3% of the mortgage REIT. They are the largest company in the sector but the weighting is still fairly heavy with over 30% going to the top 3 companies.

A Proxy For New Investors

When investors are running into a sector with little knowledge about how to pick individual securities, it provides a strong incentive to pick an ETF rather than individual stocks. As of 06/21/2016, REM reports having 105,250,000 shares outstanding and trading at a slight premium to NAV. During 2016, the ETF has been able to rapidly expand the share count outstanding which suggests that investors have been strongly buying REM when they don't feel comfortable buying the underlying companies. Given how inefficient prices are in this sector right now, I think it makes dramatically more sense for investors to carefully select individual securities.

It is a little hilarious that the ETF can trade slightly under the NAV (net asset value) of the shares while most mortgage REITs trade at a discount to their NAV.

Interest Rates

The yield curve was flattening in the first quarter but is headed towards the end of the second quarter at a level that is roughly flat from what was seen at the start of the quarter. Despite the flatter yield curve, the rates on MBS are still indicating a reasonable spread between the yields available on MBS relative to the cost of hedging the portfolio with LIBOR swaps.

An increase in interest rates on MBS would result in book value losses for the mREITs as the more compelling new securities would drive down demand for the older securities, but a reduction in amortization charges from slower prepayments combined with relatively steady short term rates (IE 3 months) would give many mREITs some improvement in their Net Interest Margin and Net Interest Spread.

While prices for MBS have moved up and down some this quarter, they are currently pretty much flat from where they started the quarter despite treasury yields declining slightly.

Declining Dividends

The mortgage REIT sector has a mix of sustainable dividends and unsustainable dividends, but there are very few mortgage REITs that will be in a position to raise dividends. Therefore, I would expect the dividend rate (that is actual cash dividends per share of the ETF) to decline over the next 12 months.

Conclusion

REM is an option for investors seeking a higher yield, but it would be a mistake to believe that the dividend is entirely sustainable or to believe that there should be no cuts in distributions over the next year. In the wake of the Brexit event, the odds of a rate hike in the United States decreased dramatically, but the mortgage REITs were split on their positions with some preparing their portfolio for lower rates and others preparing for higher rates. Buying into a fund that holds most of the mortgage REITs puts investors in a position where they are sure to hold both the best and the worst performers.

Working for Subscribers

Since the Mortgage REIT Forum is a new exclusive research platform, the first 100 subscribers will be able to lock in their subscription rates at only $240/year. My investment ideas emphasize finding undervalued mortgage REITs, triple net lease REITs, and preferred shares. With the market at relatively high levels, there is also significant work on finding which securities are overvalued to protect investors from losing a chunk of their portfolio.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ANY MORTGAGE REIT OR THEIR PREFERRED SHARES over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.