Is a 14% yield in the current interest rate environment too good to be true?

Income investors have a new ETF choice with this week’s launch of a mortgage REIT fund by Van Eck Global (MORT).

The ETF tracks an index of publicly traded mortgage REITS which make money not by investing in real estate, but by investing in mortgages.  The basic idea is to borrow short term at low interest rates and lend long term at higher interest rates.  The mortgage REIT companies then juice their yields by leveraging their balance sheets.

A good example is MORT’s largest holding – Annaly Capital Management (NLY).  As of June 30, the company had total assets of $100 billion and short term debt of $78 billion while delivering an annualized dividend yield of 14.2%.

Does this business model work?

Looking back to 1998, Annaly has delivered a total return of 100% compared to a roughly 25% total return for the S&P 500. After a 50% recovery coming out of the financial crisis, Annaly’s stock price has been fairly steady over the past couple of years.

What’s the catch?

There are a couple of key risks involved with mortgage REITs.  First, the entire business model depends on low short term interest rates and higher long term rates.  The steeper the yield curve, the better.  If the yield curve flattens or even inverses, then the business model blows up.

Second, the model also somewhat relies on low prepayment risk.  If home values rise and interest rates stay low, then we are likely to see a wave of refinancing.  However, in the current environment, 10 million homeowners are still under water with the value of their mortgages higher than the value of their homes.  In those cases, refinancing is unlikely.

The mortgage REIT companies are also highly dependent on the short term debt market.  If liquidity drys up again, then some of the firms could be affected.  That said, Annaly made it through 2008 – 2009 in better shape than the rest of the stock market.

The case for growth

Van Eck believes that the mortgage REIT companies have a solid case for potential growth.  70% of mortgage originations are now made by the 4 largest banks and the US government dominates the securitization market.  As Fannie and Freddie are restructured and the role of government in the mortgage market pulls back, the opportunity for mortgage REITs to play a larger role will open up.

 

– ETF MarketPro Staff

19 August 2011