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ETF Specialist

No Surprises Here: Mortgage REITs Stumble

Although this ETF offers almost unparalleled yield, it comes with significant risk.

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Mortgage REITs are a polarizing asset, either loved (for their yield) or despised (for their risk) by investors. The bears must be feeling vindicated now, as the market's emotional response to the Fed's recent announcements sent  iShares Mortgage Real Estate Capped (REM) into a nosedive since the beginning of April. REM lost a stomach-churning 19% over the past three months, driven by instability in the yield curve and falling book values. For investors considering an allocation to REM, the sharp decline of mortgage REITs over recent months should serve as a reminder of this asset's high risk profile. Mortgage REITs' double-digit yield, while attractive, is a flashing signal that this subsector is only appropriate for very risk-tolerant investors willing to make a bet on future rates. On the upside, mortgage REIT valuation is fast approaching post-2008 discount levels.

Not to be confused with equity REITs, which generate income by managing properties and collecting rent, mortgage REITs are financial firms that arbitrage the spread between the short-term interest rate and income from mortgage-backed securities. Mortgage REITs do not have access to deposit funding, so they rely on short-term loans like repurchase agreements. The largest firms purchase federally guaranteed securities from Freddie Mac and Fannie Mae.

Abby Woodham does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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