Appearances can be deceiving. While on the surface everything
these days seems to be moving along without a hitch, there is a
huge underlying force steering the U.S.economy .
I am not talking about a dark and evil conspiracy plotting to
overthrow the government. The force I am talking about is much
more mundane -- yet it is more powerful than any political
movement. In fact, it takes billions of dollars each day toput
the reins on the world's most powerful economic control
This vast force is better known as interest rates.
Sorry to disappoint anyone hoping for a revelation here, but
the power of interest rates is beyond any need to
exaggerate.Stock prices, economic growth, and even the rise and
fall of empires can be tied to the interest-rate equation.
Stock investors feel the effects of interest rates every day
in their portfolio. The old rhyming maxim "When rates are
low,stocks will grow; when rates are high, stocks will die"
couldn't be more accurate. The extremebull market we have
witnessed over the past several years is directly tied to
ultra-low interest rates. However, there is a big change brewing
just under the economy's surface.
Interest rates are starting to creep higher, and the
stockrally is slowing. The first stock investors to directly feel
the negative effects of rising interest rates are those who hold
instruments directly tied to rates, such asmortgage real estate
investment trusts (known as mortgage REITs ormREITs ).
These formerly top-performingdividend machines have been
smacked lower since rates started inching up in May. Favorites
are trading lower by 25% and 20%, respectively. On average,
mortgage REITs are down by more than 18% on theyear .
The reason for this is that REITs need to borrowmoney to
increase their assets. Therefore, any small decline inasset
values can have a multiplicative effect on theirequity . When
interest rates are stable, mortgage REITs outperform Treasurys.
The opposite also holds true: Mortgage REITsunderperform in an
environment of rising interest rates. This is known asconvexity ,
and simply put, convexity risk is what has knocked the mortgage
Fortunately, not all mortgage REIT stocks have been punished
to the extent that American Capital Group and Annaly have. The
primary reason is that both those mortgage REITs are built on
fixed-interest rates. Simply, fixed-rate mortgage REITs are more
affected by climbing interest rates than their adjustable-rate
and hybrid peers.
This has to do with the way adjustable-rate mortgage and
hybrid REITs are leveraged. For example, hybrid REITs are
leveraged, on average, just three to six times; compared this
with fixed REITs, which are leveraged at six to nine
Let's take a closer look at an adjustable-rate mortgage REIT
and a hybrid mortgage REIT.
Capstead Mortgage (NYSE:
This adjustable-rate mortgage REIT is trading higher by nearly
10% this year. It pays an annual dividend of $1.68, which equals
a 10.8%yield .
MFA Financial (
This is a hybrid mortgage REIT consisting of both adjustable and
regular mortgages. It is trading higher by nearly 10% on the year
but is off by 3% over the past few weeks. Yielding nearly 17%
with an annual dividend of $1.58, this hybrid REIT is a top
Risks to Consider:
During the past week, all mortgage REITs have bounced higher
on stabilizing interest ratespeculation . Although
adjustable-rate and hybrid mortgage REITs have a much higher
tolerance for rising rates than fixed-rate mortgage REITs, most
mortgage REITs are negatively affected by rising rates. With the
rates so low, it is only a matter of time until they start rising
again. Use caution in this sector because the high yieldsmean
equally high risk.
Action to Take -->
The mortgage REIT sector is extremely attractive due to the
higher than normal yields thrown off by these stocks. If you
believe higher interest rates are inevitable, avoiding the
standard fixed-rate agency mortgage REITs makes sense for
everyone but short-term traders. However, longer-term investors
cangain protection from rising interest rates but still retain
exposure to the high-yielding sector byinvesting in hybrid or
adjustable-rate mortgage REITs. I still see opportunity for
longer-term investors in adjustable-rate and hybrid REITs despite
the inevitability of interest rate increases.