Real estate stocks have taken a beating in recent months as rising interest rates derail the momentum of this beloved income sector. Yet despite the dip in traditional housing and commercial REITs, one high yield segment of the market is still seeing surging prices.
Mortgage REITs (or mREITs) have largely ignored the trend in Treasury bonds and instead focused on the continued strength in overall credit conditions. This has translated into new all-time highs for the small group of exchange-traded funds that track these investments.
To review, mortgage REITs are an alternative income-generating vehicle versus traditional stocks or bonds. These companies borrow short-term money at cheap interest rates and use it to buy long-term mortgage-related debt. This enables them to pocket the spread on interest rates and distribute the majority of earnings to shareholders as income. They also use embedded leverage to increase their capital at risk.
The largest fund by a wide margin in this arena is the iShares Mortgage Real Estate Capped ETF (NYSEARCA:REM), which as $1.2 billion in total assets. This ETF is home to a diverse basket of 36 mREITs with top holdings in well-known names such as Annaly Capital Management, Inc. (NYSE:NLY) and AGNC Investment Corp (NASDAQ:AGNC). The index is market cap weighted, which gives the largest share of assets to the biggest companies. As such, NLY and AGNC make up over 28% of the total asset allocation.
REM is one of a very select group of ETFs that offers a yield north of 9%. For comparison purposes, junk bond indexes currently yield 6%, investment grade bonds 3%, and Treasuries in the low 2% range. During dips in price, REM has even been known to offer investors an income stream that touches double digits. That’s an extremely wide spread to Treasuries and other high quality debt instruments. It’s also worth noting that income is paid quarterly to investors in these funds, rather than monthly as many bond funds do.
The thing I always caution investors about when they get googly-eyed over yield is to remember that there is no free lunch in the income world. The larger the income stream, the greater risk of volatility and capital deprecation. That is why these tools should be used in moderation and with the understanding that they are at the upper end of the risk scale.