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No free lunch with high yields

By Sheyna Steiner · Bankrate.com
Tuesday, August 6, 2013
Posted: 3 pm ET

Investors have looked high and low in the search for yield. With traditional sources of income all but extinguished, some investors may have been tempted by the high yields on mortgage real estate investment trusts, or mortgage REITs. The rise in interest rates over the past few months has shown how volatile these investments can be.

Mortgage REITs, sometimes called "mREITs," are a type of company that invests pretty much exclusively in mortgage-backed securities. Because of their tax structure, REITs must pay out at least 90 percent of their earnings to their investors.

They've been very popular with investors because of their high-dividend yields. Though the price of shares in some big mortgage REITs has been on a downward trajectory since spring, dividend yields are still above 10 percent. For instance, Hatteras Financial Corp. shows a dividend yield of 14.69 percent, and Annaly Capital Management shows 13.89 percent, according to Dividend.com. Annaly shares are down 27.47 percent since the end of April. Hatteras is down 29.82 percent, according to Yahoo Finance.

Though the investments are sensitive to interest rate changes, "In times of stagnant economic growth, such as now, mortgage REITs can serve as a hedge against other underperforming portions of a portfolio, such as (certificates of deposit) or short-term Treasuries," says Andrew Schrage, founder and CEO of the website MoneyCrashers.com.

Rising interest rates

What's causing all the upheaval in prices? Interest rates: With the Fed talking about slowing bond purchases, mortgage and borrowing rates have increased -- and that's bad news for mortgage REITs, at least in the short term.

Mortgage REITs borrow money to buy pools of mortgage debt. Right now the cost of borrowing is still extremely low, which helps the REITs make money -- they can borrow for a small price and then make much more money by turning around and purchasing assets -- mortgages with a higher interest rate. As rates increase, the cost of doing business, borrowing, will get more expensive. While short-term rates go up, the value of their investments, like bonds, will decrease.

"Mortgage REITs borrow short and lend long. The shape of the yield curve impacts cash flow immensely. At the same time, they are highly leveraged. If the value of the mortgage securities they hold falls significantly in value, they can find themselves in a very dangerous financial position," says Stephen Mauzy, CFA, principal at S.P. Mauzy and Associates in Denver.

"When interest rates rise, the cost of the carry trade -- borrowing at one rate to buy assets at another -- rises and becomes more risky. There is a risk to having mismatched funding," he says.

Mortgage REITs attempt to mitigate the risk of rising interest rates with interest rate swaps, a type of derivative contract. After the significant declines the investments have shown since May, investors may be wondering how effective those hedging strategies really are.

According to Richard Farrington, editor-in-chief of TheCollegeInvestor.com, the hedges have actually worked so far this quarter.

"The trouble is, interest rates have been all over the place, and so it has made it very difficult for the REITs to adjust. You can see the results from the hedges in the better-than-expected decline in book value of the REITs. All REITs lost significant book value over the quarter, but not as much as analysts predicted -- which shows that the hedges were working. Furthermore, as a result of the book-value decline, almost all mREITs cut their dividend -- but once again, not as much as expected," he says.

As long as portfolio earnings outstrip the cost of borrowing, mortgage REITs have the opportunity to be profitable. But there will be volatility and choppiness as they adjust to the changes in rates.

"Remember, REITs make their money from the spread at which they can borrow versus what their loan portfolios are at. Right now, that spread is anywhere from 1.5 percent to 2.3 percent, depending on the REIT. The thing that investors need to look at is whether that changed during the quarter," says Farrington.

"For popular funds (such as American Capital Agency Corp.), the spread remained the same all quarter, despite the book-value drop and dividend decrease. That shows that the fund management is aggressively hedging and also replacing their loan portfolio with higher-yielding loans as rates rise," he says.

Do you hold any mortgage REITs? What do you think -- since prices have dropped, is now the time to buy them, or would you steer clear of the volatile investments?

Follow me on Twitter: @SheynaSteiner.

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Senior investing reporter Sheyna Steiner is a co-author of "Future Millionaires' Guidebook," an e-book written by Bankrate editors and reporters. It's available at all the major e-book retailers.

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