Recently, fellow Seeking Alpha contributor, Neal Razi, published an article titled *"*Rising Interest Rates Present Buying Opportunity for Annaly Capital and Other Mortgage REITs*"*. As the title suggests, in his article, Neal claims that higher interest rates will increase the interest spread, which, in turn, will boost the future profits of mortgage-backed real estate investment trusts [mREITs].

I agree that a wider interest spread will boost mREITs' future profits. However, higher interest rates do not necessarily imply a higher spread. In fact, higher interest rates can have instantly devastating effects on the mREITs' balance sheet. mREITs market value is almost perfectly correlated with their book. As higher interest rates will reduce their book value, the market valuations will also suffer. Therefore, mREIT investors might be interested in hedging their positions against the threat posed by higher long-term interest rates. In this article, I explain the effect of higher long-term interest rates on mREITs' profitability. Unlike Neal Razi, I suggest that higher long-term interest rates present a significant threat to **Annaly Capital (NLY)** and other mortgage REITs. I also suggest some actions to take against rising interest rates. Now, before we move into the details, let me explain mREITs' business model first.

**Mortgage-Backed Real Estate Investment Trusts - Business Model**

The business model of mREITs is pretty simple. These institutions operate as pseudo-banks, acquiring short-term loans to invest in long-term mortgage-backed securities. They are usually managed by external management teams. The management invests in securitized long-term loans, which are originally borrowed by the property owners. The financing comes from low-interest borrowing. Thus, these companies finance their long-term investments by short-term borrowing.

As SA contributor John Dalt suggests, mREITs use leverage in their balance sheets, to make the most out of the interest-rate spread. Consider Annaly Capital for example: Its current debt/equity ratio is 5.41, suggesting a leverage ratio near that level. This leverage ratio shows the way Annaly finances its current mortgage-backed loan portfolio. About 80% of its assets are financed through short-term debt. Thanks to this leverage, the company was able to provide an average return on equity of 13.42%, from an interest spread of 2% - 3% between long-term mortgage securities and short-term securities.

About 90% of Annaly's portfolio consists of fixed-rate mortgage-backed securities and agency departures. 10% of the portfolio is invested in adjustable-rate securities and agency departures. 38% of the portfolio is insured through interest swap agreements. Thus, Annaly is already engaged in interest swap agreements to mitigate the interest risks, locking in the spread, but that portion is only 38% of its mortgage portfolio.

Due to their unique structure, mREITs are subject to several risks. Mortgage-default risk and yield-spread contraction risk are unique to mREITs' business area. Mortgage-default risk is specific to hybrid mREITs, which also invest in non-agency backed mortgage instruments. Yield-spread contraction risk is closely related to FED's monetary policy. Most mREITs use some sort of leverage to exploit the difference between short-term and long-term interest rates. Therefore, a reduction in the yield-spread can have a multiplicative effect on their future profits.

**Effect of Interest Rate Change on mREITs' Balance Sheet**

Before we talk about interest rates, we need to make the distinction between short-term and long-term interest rates. Currently, long-term (30-year) bonds offer interest rates of about 3%, whereas short-term (5-year) notes offer an interest rate of 0.5%.

*click to enlarge images*

(Graph is based on Federal Bank of St. Louis Data)

What we care is the slope of this curve. While it is not the exact yield curve faced by individual mREITs, the above graph suggests a very good general proxy. A steeper yield curve is a good thing for the future profits, whereas a flatter yield curve can crush the future distributions. If the short-term interest rates stay constant, with long-term interest rates going up, that is an admirable thing for the future distributions. If it is just the short-term interest rates going up, while the long-term interest rates stay constant, that is a dreadful thing for the future distributions. However, historically short-term and long-term interest rates move together. Let's assume that the interest rates rise together, keeping that the spread constant.

Since we assumed constant spread, rising interest rates would not make much difference in long-term profits. However, mREITs operate as giant investment funds that invest in long-term mortgage-backed securities. Their market value closely follows their book value. The book value is based on the total net value of assets in the portfolio. And the value of these assets instantly changes along with the yields they offer. There is a direct negative relation between interest rates and bond-like security valuations. The price of a bond is determined by using the interest yield as a discount rate. A higher interest rate implies a higher discount rate, which translates into a lower valuation for the bond.

Consider the 10-year Treasury notes. In the last year, these notes returned 17%, while they offered a yield of only 1.88%. How did this happen? It happened as a result of price appreciation due to lower yields. At the beginning of 2011, the yield on these notes were 3.31%, which declined by 143 points to 1.88% by the end of the year. Thanks to this decline in the interest rates, the bond holders made double-digit returns in the last year. Given the record-low yields, the future interest rates have nowhere to go, but up. This move will surely hurt the bond-holders including mREITs.

**Suggestions to Hedge Against Rising Interest Rates**

Leveraged mREITs are more prone to be negatively affected by the rise in interest rates. Therefore investors might consider switching from high-leverage mREITs to low-leveraged mREITs. Currently Annaly Capital has a leverage ratio of 5.4. **Chimera (CIM)**, on the other hand, has the same management team with Annaly Capital, but it has a relatively lower leverage ratio of 1.85. **American Capital Agency (AGNC)** and **American Capital Mortgage (MTGE)** are two companies beyond the Annaly space. American Capital Agency has a leverage ratio of 7.82, and American Capital Mortgage has a leverage ratio of 8. Apparently, these mREITs carry more risk with them. Another well known mREIT, **Armour Residential (ARR)** is currently leveraged by 8.52 times. Staying within the Annaly space looks like a better option for risk adverse investors.

Another action that could be taken by mREIT investors is to hedge their portfolio against the rise in long-term interest rates. Shorting **iShares 20+ year Treasury bond ETF (TLT)** is one option. With a short float of 62.70%, this fund is already among the most heavily shorted ETFs in the ETF world. **Proshares Ultrashort 20+ year Treasury ETF (TBT)** is another option to play the rise in long-term interest rates. This ETF aims to replicate twice the opposite daily performance of long-term Treasury bonds. Therefore, it could be an effective way to hedge your mREIT portfolio against rising interest rates.

**Disclosure: **I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.