How to Hedge mREIT Portfolios for Rising Rates

Mortgage REITs reward investors with lofty dividends, but when rates rise, mREIT share prices bomb.

We only need to look to mREITs like Western Asset Mortgage Capital Corp. (NYSE: WMC  ) and Annaly Capital Corp. (NYSE: NLY  ) to see the carnage over the past year. Both continue to trade below book value as investors worry about the potential for future capital losses.

Even one of the best hedged mortgage REITs, Two Harbors Investment Corp. (NYSE: TWO  ) , is among mortgage REITs with a negative year-to-date price return. Two Harbors' managers have been the most active in insulating the company from rising interest rates, but that isn't enough to keep it in the green.

NLY Chart

NLY data by YCharts.

How you can protect your portfolio
Rising rates have a negative industrywide effect on mortgage REITs. For dividend seekers, that could spell trouble if the Fed moves to reduce its bond buying and cut back on quantitative easing.

Fortunately, there's a way to hedge against these risks by swapping some high-yield mREITs for lower yield insurance stocks.

Um, what?

You might be thinking I've fallen off my rocker inserting insurance into an article on mortgage REITs, but hear me out: When it comes to interest rate sensitivity, insurance companies should benefit, not lose, from rising rates. When rates go up, returns on an insurance company's investment portfolio follow. That means their net income is positively correlated to higher rates over long periods of time. Thus, insurance stocks can act as a hedge to an mREIT portfolio.

Insurance companies are in a very similar business to mortgage REITs. They "borrow" money paid in through premiums to invest in investment-grade bonds using leverage. That's awfully similar to Two Harbors, Western Asset Mortgage Corp., and Annaly Capital, which borrow to invest in mortgages with borrowed money.

One insurance stalwart should be on your radar. The Chubb Corporation (NYSE: CB  ) is both an excellent insurance underwriter and investor. It writes insurance profitability and tops off those profits with gains from its investment portfolio, which is funded by insurance premiums.

Dividends aren't everything
Now, The Chubb Corporation doesn't pay a big dividend. If you buy now, you'll earn a yield of just 2%. But over its history, the company has quietly repurchased a significant 26% of its own stock, driving down share count and pushing its share price higher.

Not to mention, over the past 10 years, it made money in every single year, while posting double-digit returns on equity in all but 2012. Those double-digit returns on equity flow into repurchases, which drive higher per-share prices, ultimately rewarding investors.

All in all, investors who own Two Harbors, Western Asset Management, and Annaly Capital Management for the dividend yield may be better suited with a portfolio that includes top-quality insurance companies alongside high-dividend mREITs.

Insurance companies can provide relatively stable double-digits returns on equity and big returns for investors while paying a modest dividend. Over the long haul, an insurance company's investment profits should zig when mREITs zag, providing diversification without crushing the performance of the total portfolio.

New ways to protect your dividend income
Dividend stocks can make you rich. It's as simple as that. While they don't garner the notoriety of high-flying growth stocks, they're also less likely to crash and burn. And over the long term, the compounding effect of the quarterly payouts, as well as their growth, adds up faster than most investors imagine. With this in mind, our analysts sat down to identify the absolute best of the best when it comes to rock-solid dividend stocks, drawing up a list in this free report of nine that fit the bill. To discover the identities of these companies before the rest of the market catches on, you can download this valuable free report by simply clicking here now.


Read/Post Comments (3) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 22, 2013, at 2:17 PM, sailrmac wrote:

    You are correct that insurance companies provide a good hedge against mREIT's. They do so because there large asset bases tend to be invested in short term securities. As interest rates go up so do their earnings from these securities. Another asset that increases in value when rates go up is Mortgage Servicing Rights. People are less likely to refinance when rates go up so MSR's payments last for a longer period of time. Names like New Residential and Ocwen benefit. So they are also good hedges on mREIT's.

  • Report this Comment On October 23, 2013, at 12:09 PM, TMFValueMagnet wrote:

    Sailrmac, thanks for your comment. I actually have a post in the pipeline on MSRs, and how Two Harbors is using them to hedge their MBS portfolios.

    Excess MSRs can be a great asset. I'll take a peek into New Residential and Ocwen.

  • Report this Comment On November 04, 2013, at 4:01 PM, RegLeCrisp wrote:

    What about the asset write-downs on the bonds that are going to lose value with higher rates? The companies with the shorter duration liabilities should do better, but it's an issue, no?

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2692016, ~/Articles/ArticleHandler.aspx, 10/2/2014 8:34:09 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated 11 hours ago Sponsored by:
DOW 16,804.71 -238.19 -1.40%
S&P 500 1,946.16 -26.13 -1.32%
NASD 4,422.09 -71.31 -1.59%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

10/1/2014 4:00 PM
CB $90.77 Down -0.31 -0.34%
The Chubb Corp CAPS Rating: ****
NLY $10.97 Up +0.29 +2.72%
Annaly Capital Man… CAPS Rating: ****
TWO $9.83 Up +0.16 +1.65%
Two Harbors Invest… CAPS Rating: ****
WMC $14.23 Up +0.15 +1.07%
WESTERN ASSET MORT… CAPS Rating: *****

Advertisement