Is The Plunge Over For Mortgage REIT ETFs?

reitIn investors’ search for high yielding securities, many have taken a closer look at the mortgage REIT (mREIT for short) market for exposure. This segment has benefited from low short-term rates and monetary easing policies (QE3), which have lowered borrowing costs which in turn have made the higher yielding REIT space an attractive one to be in.

mREITs in Focus

Unlike equity REITs, mortgage REITs do not hold properties, but invest mainly in mortgage backed securities (MBS) instead. These use short-term debt for financing their purchases and are usually highly leveraged.

Securities in this segment are among the highest yielders in the equity world thanks to their combination of leverage and real estate holdings. But since these are REITs, a pay out of at least 90% of earnings to holders is mandatory in order to obtain a favorable tax treatment. With this focus, many mREITs pay out double-digit yields, handily crushing broad Treasury bond markets and other dividend payers (read: Two Sector ETFs Posting Incredible Gains).

Thanks to this structure, mREIT offer up a very compelling risk reward play. That is because these REITs borrow capital at ultra low short-term rates, and then invest in potentially higher yielding real estate portfolios. Basically, securities in this segment often use leverage to make money off of the spread differential in rates while still paying out high yields to investors on a regular basis.

Risk Ahead?

While this space has been extremely popular to start the year, many have begun to think twice about the segment. That is because new risks from the Federal Reserve, along with a general disdain for high yielding securities, could hamper the outlook for these securities going forward.

This is largely thanks to the growing signals from the Fed to slow or stop its asset-purchase program, which have weighed heavily on the prospects for mREITs. This is because the current Fed policies keep short-term rates low and help the spread stay high for mREIT companies.

But, if short term rates rise and medium to long term rates creep up, it will cut into the spread and thereby crush profit margins for the space. Obviously, this is poor news for mREIT investors, especially considering the high leverage for many firms in this corner of the market.

Still, once rates level off, mREITs could be presenting themselves as solid value picks at this time. That is because these are among the biggest yielders in the market, and after the recent pull back could be at more reasonable valuations.

Given this, some investors might want to pay close attention to the mREIT ETF market in the near term. If rates top out here, it could be time to buy these high yielders, but if bond prices continue to fall, it may be worth it to avoid the following ETFs at this time:

Mortgage REIT ETFs in Focus

iShares FTSE NAREIT Mortgage Plus Capped Index Fund (NYSEARCA:REM)

This is the most popular mREIT ETF on the market with about $1.1 billion in AUM and just under one million shares a day in average volume. The ETF tracks the FTSE NAREIT All Mortgage Capped Index and holds 29 securities in its basket.

The fund has a heavy concentration across its top securities, as Annaly Capital (NLY) accounts for 21% of the total assets alone and American Capital Agency (AGNC) makes up for another 16.4%. Other security holds less than 7.5% share. The product is well spread across the market spectrum allocating 37% to large caps, 21% to mid caps and the rest to small caps.

The product charges investors little higher than 48 basis points a year in fees. Obviously, the yield is the real focus of this fund, as the 30-Day SEC payout comes in at a robust 10.70%.

Market Vectors Mortgage REIT Income ETF (NYSEARCA:MORT)

This fund follows the Market Vectors Global Mortgage REITs Index while trades in average volumes of more than 53,000 shares per day, and manages an asset base of $121.8 million. Investors need to pay a fee of 40 basis points annually for this fund, so it is a middle-of-the-road ETF in terms of expenses.

With holdings of 26 securities, the product puts 67.52% of the assets in the top 10 companies, suggesting a heavy concentration across individual firms. Annaly Capital and American Capital Agency take the top two spots with 16.05% and 14.18% share, respectively. Other firms do not hold more than 5.17% of MORT’s assets.

The ETF focuses on small cap firms with more than half of the portfolio going to this cap level. Yields are impressive in this ETF as well, as the 30 Day SEC payout comes in at 11.07%, just edging out REM in this respect.

ETRACS Monthly Pay 2x leveraged MREIT Index ETN (NYSEARCA:MORL)

This is the newest addition to the mREIT space, debuting in October 2012. The fund seeks to deliver two times (2x or 200%) exposure to the performance of the Market Vectors Global Mortgage REIT Index on a monthly basis.

This results in a fund that is volatile, although it also hopes to be a big yielder. In fact, the expected yield comes in at 24.82% per year, more than enough to make up for the 40 bps fee per year.

With that being said, investors should note that the product is structured as an ETN so there is some credit risk from UBS, although tracking error will not be an issue. The note has amassed only $65.1 million in AUM and trades in average daily volume of more than 100,000 shares.

The ETN does, however, look to be a yield king as there are no other products with a 20%+ yield like this one in the mREIT space. So for truly yield starved investors this could be an interesting choice, especially with high risk tolerance and a belief that the mREIT space might perform better in the weeks ahead.

Bottom Line

MREIT ETFs have been pretty intriguing investments for much of 2013, as demand for high dividend securities was quite robust. However, as Treasury yields have slowly begun to rise, the appeal of these high yielders have been significantly curtailed.

The spread differential—between the MBS and the shorter term debt—has shrunk and this is hurting the outlook for mREIT ETFs, causing many to sell-off their holdings in these once big winners. While you can certainly argue that the sell-off is overdone, trading could remain dicey in this corner of the market until more clarity is established in terms of the Fed’s policy on rates.

Given this situation, you may want to utilize a wait-and-see approach for the time being in the mREIT ETF market. The space could go either way from here, though one has to think that the sell-off has been pretty extreme and that a short-covering reversal is in the cards shortly (read:Is the Panic Over for Mortgage REIT ETFs?).

This article is brought to you courtesy of Eric Dutram From Zacks.

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