While mortgage REITs (or mortgage real estate investment trusts) are well-known for their high dividend yields and high dividend yields it is important for investors to understand how interest rate fluctuations can affect them. This is how it works.Fool LiveVideo clipDec. 10Fool.com contributors Marc Rapport, CFP and Matt Frankel discuss how a rising rate environment might impact mortgage REIT investments.
Matt Frankel:Mortgage REITs are able to borrow money to finance their operations. They can be very vulnerable to interest rate fluctuations.
There are two sides to this story. Rates unexpectedly rise and mortgage REITs pay higher short-term borrowing interest rates to borrow money. However, the interest they collect on their mortgages remains the same. They are paying more to borrow money, but they don’t collect any rate increases, so you will see the profit margin begin to shrink. 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.
It might sound good to see rates fall unexpectedly, but it’s often a sign that borrowers are pre-paying their mortgages. Think back to the refinancing boom of the past year and half. 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 will 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 a hedged against by mortgage REITs. I don’t want to do too much hedging, such as interest rates swaps, but they can’t eliminate the risk completely. With this in mind, I wanted to get out of PowerPoint. We are now done. This is Marc’s screen. I would like to see his thoughts on this as a dividend investor. Just a second. Right now, I’m not using a mouse. I’m back at the Stone Age.
Marc Rapport:Would you like me to bring one to you?
Matt Frankel:I have one. I don’t have enough USB ports so I can hook up all this stuff.
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 goal is Annaly‘s (NYSE:NLY)Stock price. It is evident that its stock price fell by 22% in the past two years. Investors did not lose it unless the stock was sold, but their investment was worth 22% less. Their dividend is their bottom.
It is not uncommon for mortgage REITs that have higher rates to have to reduce their dividends as the profit margin 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.
This article is the author’s opinion. He or she may disagree with the official recommendation of a Motley Fool premium advisory services. Were we motley! Were motley!