The allure of high yields is something that income investors are always tempted to chase. When you couple an outsized dividend payout with an explosion of momentum, the attraction can become even further exacerbated. This is exactly what happened earlier this month when Jeffrey Gundlach offered a recommendation for investors to purchase the iShares Mortgage Real Estate Capped ETF (REM) and simultaneously short the Utility Select Sector SPDR (XLU).
Since that call, REM has only experienced a single minimal down day among nine trading sessions and daily volume has exploded in kind. The chart below shows how much Gundlach’s recommendations carry weight throughout the income-focused investment community.
For those who aren’t familiar with REM, this exchange-traded fund tracks a basket of 38 mortgage REITs in a market cap weighted structure. Top holdings include: Annaly Capital Management REIT (NLY) and American Capital Agency REIT (AGNC), which make up nearly 31% of the asset allocation.
Mortgage REITs offer tremendous distribution rates as noted in the current 11.57% 30-day SEC yield of REM. Income is paid quarterly to shareholders in this fund, which has $942 million in total assets. REM also charges an expense ratio of 0.48%.
These companies are considered financial stocks that generate their fantastic yields by borrowing short-term money at low rates and purchasing longer-term mortgage bonds with the proceeds. They are then able to earn the spread between these rates and often use leverage to enhance their purchasing power.
This financial engineering may seem like a benefit for investors who want to enhance their overall portfolio yield. However, those that have been in the game long enough realize that high yield brings with it a concomitant higher risk of price volatility as well. That is the tradeoff you assume when moving towards more credit sensitive holdings that offer exponentially greater income streams relative to an investment grade corporate or Treasury bond.
REM is now up nearly 11% on a year-to-date basis and 5% in the month of May alone. Furthermore, the halo effect of Gundlach’s endorsement has trickled down to other funds in this class as well. The VanEck Vectors Mortgage REIT Income ETF (MORT) tracks a similar basket of mortgage REITs and has experienced an almost identical performance gain this year.
For those willing to take on even greater risk, the ETRACS Monthly Pay 2xLeveraged Mortgage REIT ETN (MORL) offers a leveraged play on this sector. MORL is an exchange-traded note that magnifies the yield and price of the mortgage REIT index with a monthly dividend payout schedule. The current yield of MORL is an astounding 20.27%, according to the fund company website.
Despite Gundlach’s blessing, implementing these mortgage REIT ETFs in the context of a diversified income portfolio may not be so simple. Investors must grapple with the embedded use of leverage in the underlying components alongside sensitivity to credit and interest rate fundamentals. The higher volatility of these funds versus traditional common dividend stocks or bonds likely means that they are more appropriate as tactical assets rather than core holdings. More conservative investors must weigh the pros and cons of purchasing these funds for their yield enhancing properties versus the associated risks they may introduce.
The Bottom Line
Mortgage REITs offer an alternative means of generating high yields outside of conventional REITs, junk bonds, preferred stocks, or business development companies. However, these vehicles carry with them unique risks that are often exacerbated during periods of stress in the fixed-income markets.
Investors considering the use of these funds should be cognizant that there is no free lunch when it comes to the search for high yield and size their positions accordingly.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.