Navigating High Yields: Unpacking the Dynamics of Mortgage REITs and BDCs
Mortgage REITs Outperforming Business Development Companies: A Surprising Trend
Traditionally, Business Development Companies (BDCs) have held a dominant position, but this year has witnessed a remarkable shift, with mortgage REITs (mREITs) demonstrating superior performance. This unexpected turn of events is primarily influenced by two critical factors: a downward trend in short-term interest rates and investor apprehension towards unrelated loans following a few borrower bankruptcies. This analysis will concentrate on the recent upward trajectory of mortgage REITs, distinguishing it from previous discussions on BDCs.
Exploring Recent Performance: A Look at Sector-Specific ETFs
To evaluate the recent performance, we utilize the $100,000 chart, a tool that effectively illustrates how past investments would have fared across various timeframes. This method is particularly insightful as it accounts for dividends, which are a substantial component of returns for high-yield investments, albeit accompanied by inherent risks. The chart highlights the significant outperformance of the VanEck Mortgage REIT Income ETF (MORT) compared to the VanEck BDC Income ETF (BIZD) and Putnam BDC Income ETF (PBDC) over the past year, in some instances quite substantially.
Understanding the Composition: A Glimpse into the Mortgage REIT ETF Holdings
A closer look at the holdings of the VanEck Mortgage REIT Income ETF (MORT) reveals that its top two positions are concentrated in agency mortgage-backed securities-focused mortgage REITs. These entities are highly sensitive to interest rate movements, yet their exposure is frequently misunderstood by investors.
Common Misconceptions: Interest Rate Sensitivity in Mortgage REITs
Many investors mistakenly believe that mortgage REITs, particularly those dealing in agency mortgages, always benefit from lower interest rates. However, a significant drop in mortgage rates can negatively impact these REITs. This occurs because lower rates can lead to a surge in prepayments of mortgages with higher coupon rates, which can be detrimental to the mortgage REITs' financial health.
The Mechanism of Prepayment: Why Lower Rates Can Hurt
Mortgage prepayments typically occur through refinancing, home sales, or accelerated principal payments. The first scenario, refinancing, is particularly sensitive to interest rate drops. When mortgage rates decline, homeowners with higher-rate mortgages are incentivized to refinance, leading to an increase in prepayments that can disrupt a mortgage REIT's portfolio strategy. For instance, my own mortgage, locked in at a low 2.125%, serves as a personal example of why one might choose to invest in short-term Treasuries rather than pay extra principal, highlighting the opportunity cost of high-rate mortgages.
Navigating the Upside: The Impact of Rising Interest Rates on Mortgage REITs
While the current market conversation revolves around falling rates, it's equally important to consider the implications of rising rates. Mortgage REITs typically do not favor significant rate increases because their mortgage-backed securities (MBS) holdings would lose value, financing costs would escalate, and prepayments would decrease too much, slowing down capital reinvestment. Mortgage REITs ideally prefer a stable interest rate environment with only a gradual reduction in the Fed Funds Rate.
Strategic Management: What Mortgage REITs Can Do
In a rising rate environment, mortgage REITs would gradually transition to higher-yielding mortgages, though this process is time-consuming. Selling lower-yielding mortgages would mean accepting significantly reduced prices. Consequently, they tend to adopt a less aggressive approach to portfolio management. Their optimal scenario involves mortgage rates remaining steady, coupled with a slow decrease in the Fed Funds Rate. Mortgage REITs benefit from a reduction in the Fed Funds Rate, as they often hedge a portion of their borrowing costs, allowing them to capitalize on lower short-term rates. It's a misconception that they hedge only a small fraction of their exposure; in reality, they typically hedge the substantial majority for short to medium terms, and sometimes even exceed 100%.
Current Market Assessment: Valuation and Investment Opportunities
Examining the largest mortgage REITs, which are prominent in MORT's holdings, reveals relatively high valuations. Using recent estimates, their price-to-book values are around 1.08x and 1.23x, indicating that book values for these REITs likely increased by 4% to 5% between Q3 2025 and last Friday. However, projected book value changes vary across the sector, with some mortgage REITs potentially reporting declines. While some opportunities exist for common shares, many are still priced expensively. The current environment presents a favorable time to explore preferred shares and baby bonds for their attractive yields and price stability. Though BDCs have seen more activity recently due to their price slides, a selective approach to mortgage REIT common shares could also prove beneficial, exemplified by a recent successful trade in Dynex (DX).
Analytical Approach: Valuing Mortgage REITs and BDCs
Our analysis employs a strategy centered on providing updated estimates for Book Value (BV) and Net Asset Value (NAV) for mortgage REITs and Business Development Companies (BDCs). We stress the significance of price-to-BV and price-to-NAV ratios as crucial valuation metrics. These comprehensive insights, including various metrics for baby bonds and preferred shares, are available through detailed charts.
Diverse Portfolio: An Overview of Included Companies
The charts incorporate a wide array of companies for comparison, including various BDCs, Commercial mREITs, Residential Hybrid mREITs, Residential Agency mREITs, and Residential Originator and Servicer mREITs. Notable changes include NYMT's ticker change to ADAM, affecting both its common and preferred shares/baby bonds. This broad selection allows for a thorough comparative analysis across the sector.