By Conrad de Aenlle
LONG BEACH, Calif., Sept 25 (Reuters) - The Federal Reserve pleasantly surprised the markets last week when it chose not to start curtailing debt purchases.
While bonds rallied overall, an obscure type of asset called mortgage real estate investment trusts reacted especially well, with some gaining 5 percent or more in the hours after the Fed's Sept. 18 announcement.
Mortgage REITs hold portfolios of property loans, and that makes them acutely sensitive to swings in interest rates. Mortgages, like many fixed-income instruments, rise in value when rates fall and vice versa. Rate changes can make housing more or less affordable, affecting homeowners' ability to keep up mortgage payments. Most important, because mortgage REITs typically use leverage - borrowing cheaper short-term money to make more loans than they could with their own equity - the impact of the first two factors is amplified.
That's why mortgage REITs soared after the Fed announcement, but it's also why they plunged after the Fed hinted in May that it was considering reducing debt purchases. Between May 17 and Aug. 19, the Market Vectors Mortgage REIT Income ETF fell 24 percent. It has since clawed back about a third of those losses.
Shareholders in mortgage REITs do not endure such volatility for nothing. The leverage that is so common in the sector often produces spectacular yields, such as 11 percent on the Market Vectors ETF.
That's not enough to make up for the summertime loss, but fans of mortgage REITs contend that the selling was overdone and they encourage investors to consider owning them - but only ones that limit risk in one way or another.
James Kieffer, lead manager of the Artisan Mid Cap Value Fund, views mortgage REITs as "yield-manufacturing devices" that can boost the income of a broad investment portfolio. The two that he holds, Annaly Capital Management Inc and Hatteras Financial Corp, had recent yields of 12.4 percent and 14.2 percent, respectively. He prefers them to other REITs in part because they own only government-guaranteed mortgages, which essentially eliminates default risk.
Kieffer, whose fund has outperformed its mid-cap category by 3.5 percentage points a year for the last decade, according to Morningstar, decided to be a more careful manager about a year ago.
Perhaps the biggest risk to the value of mortgage REITS is a sharp rise in interest rates. Kieffer sold about 40 percent of his mortgage REIT holdings after rates went to all-time lows and seemed likely to him to reverse course. He was right, although he said the extent of the decline caught him off guard, and he acknowledged increasing his positions, which he did early this summer, too soon.
When they did fall, mortgage REITs fell hard, and share prices dropped by more than could be accounted for by declines in their intrinsic value as interest rates rose. Price-to-book ratios fell, too. Annaly's price has fallen in the last 12 months from 1.08 times book value to 0.91, meaning the REIT can be bought for less than the market value of its loans. Hatteras likewise has gone from 1.08 times book to 0.87.
The rate risk that owners of residential mortgage REITs take on is something that Joel Beam, manager of the Forward Select Income Fund, would like to avoid. He favors REITs that hold loans on commercial property.
Beam's portfolio, which Morningstar ranks as the best five-year performer among real estate funds, owns Ares Capital Corp (ARCC.O ) and several preferred shares issued by iStar Financial Inc. Preferred shares rank higher than common stock in a company's capital structure and, similar to bonds, are deemed to be safer but have less appreciation potential.
Beam says iStar and Ares use less leverage than residential REITs, and he particularly likes iStar because its executives have considerable expertise in real estate management. "If a loan goes bad, they can take back the collateral and manage it," he said.
Commercial mortgage REITs borrow less, but they still have healthy yields, albeit smaller ones than their residential counterparts. Ares recently yielded 8.6 percent, and the five iStar preferred series had yields between 7.6 percent and 8 percent.
Expressing his disdain for residential mortgage REITs, Beam said, "I see them as very highly leveraged, four, five, six times. That worries me now when there's a lot of interest rate risk in the world. Their book values can change fast."
That worries Kieffer less. He concedes, though, that owning residential REITs can entail more rate risk than many investors can handle, so he recommends taking only small positions relative to the size of one's total portfolio.
"In the environment we're in and continue to be in, where we are likely to have low rates for a long time and an upward-sloping yield curve, they're a device that works as it was meant to," Kieffer said.
But he also warned, "These things can explode overnight on you. They're appealing vehicles with moments of volatility and fright in them."