MMortgage REITs (ortgage realestate investment trusts) are well-known for their high dividend yields. However, it is important for investors to understand how interest rate fluctuations can affect them. This is how it works. Fool LiveVideo clip Dec. 10, 2008Fool.com contributors Marc Rapport, CFP and Matt Frankel, CFP discuss how rising rates could impact mortgage REIT investments.
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Matt Frankel:Because mortgage REITs borrow money in order to finance their operations, they are highly susceptible to fluctuations in interest rates. This is true in both directions.
This has two sides. There are two sides to this story. When interest rates unexpectedly rise, short-term borrowing rates that mortgageREITs pay to borrow their money go up. But the interest they collect on the mortgages they own remains the same. They pay more to borrow money but the rates they collect don’t change, and you can see the profit margin shrink when that happens. If interest rates rise too much, it could cause the profit margin to go negative. This can also lead to a fall in the value mortgage-backed securities.
Although it may sound good, unexpectedly falling rates can often be a bad thing. However, we often see borrowers prepay their mortgages. Think about the huge refinancing boom over the past year. The mortgage REIT may think that rates are falling is a good thing, but it doesn’t matter if borrowers are prepaying their mortgages. They’ll get nothing. Rates that move unexpectedly in one direction or another can be a negative factor in mortgage REITs. I’ll show a chart about this in just a moment.
This can be backed up by mortgage REITs. I don’t want to have to do too much hedging by interest rate swaps, things such as that, but they won’t completely eliminate this risk. With this in mind, I wanted to get out of PowerPoint. We are now done. I want to share this screen with Marc. I want to know what Marc thinks about it as a dividend investor. For a moment, bear with me. I’m not using a mouse right now. I’m back in Stone Age.
Marc RapportDo you want me to bring one?
Matt Frankel:No, I do have one. I don’t have enough USB ports for all the stuff I have hooked up.
Marc Rapport Mine’s wireless. You are a dinosaur.
Matt Frankel: [Laughs]This was during the last interest rate hike cycle, which occurred from 2017-2019. The Fed was raising interest rates quite actively because the economy was doing well. The highest standard is Annaly‘s (NYSE: NLY)Stock price. The stock price dropped 22% over the two-year period. Investors did not lose it unless the stock was sold, but their investment was worth 22% less. Their dividend is the bottom.
It is not unusual for mortgage REITs that have higher rates to have to cut their dividends as the margin of profit shrinks. The stock price fell by 22% and the dividend income dropped 17%. This can be a concern for retired investors who depend on income. These are two important things to keep. … That’s where inflation and the interest rate risk come in. —Because inflation tends to lead to higher interest rate — this is where the risks really come into play.
Marc RapportAnnaly Capital Management is owned. Matthew Frankel CFPNone of the stocks are in his portfolio. The Motley Fool does not hold any position in any of these stocks. The Motley Fool has an Disclosure policy.
These views and opinions are solely the author’s and do not necessarily reflect the views of Nasdaq, Inc.