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.

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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.

Fool contributor Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.