With a deluge of positive economic data including ISM surveys, better-than-expected advance third-quarter GDP numbers and a surprising pickup in U.S. job growth in October – all braving the much-hyped ‘shutdown’ – taper concerns have resurfaced.
‘QE Taper’ and ‘rising interest rates’ have become synonymous in the market and fluctuation in interest rate regulates the fate of the U.S. Real Estate Investment Trust (REIT) sector. This is especially true in a high volatility corner of the market known as the mortgage REIT or mREIT space.
Mortgage REITs in Trouble?
mREITs generally use a short-term loan to purchase long-term securities and generate revenues from the spread between the two. Therefore, to make profits, these firms need a wide spread between the short and long-term rates. These firms are typically highly leveraged and more vulnerable to interest fluctuations than most in the REIT world.
However, securities in this space boast some of the highest yields in the equity market. This is because mREITs must pay out at least 90% of their earnings to holders for a favorable tax treatment. Also, its leveraged nature makes it a high-yielding investment proposition.
Now that the U.S. economy has grown 2.8% in the third quarter – the highest this year – exceeding the preceding quarter’s growth rate of 2.5%, the possibility of the Fed’s QE taper came into the picture. Also, a high job growth reading of 204,000 in October added to the speculation of a taper.
The commitment rate for 30-Year Fixed-Rate Mortgages that took a breather following the ‘taper hold’ in late September, crept up 6 bps to 4.16% in early November on a week-over-week basis.
Notably, the rate has seen a steady run since April when it was low at 3.45%. On the other hand, The U.S. 5-year treasury yield rose to the highs of 1.47% (as of November 12, 2013) from the lows of 0.76% at the start of the year.
If the scenario persists and short-term rates rise faster than the medium-to-long term rates following tapering, the spread between two will shrink thus hurting profit margins of mREIT companies.
Given this, investors should be at least a little concerned about the current state of the mREIT ETF market. These funds might be interesting short-candidates (or at least funds to avoid) for those who believe a taper is coming, or a solid contrarian play for investors who think that a reduction in QE isn’t coming anytime soon.