Mortgage REITs American Capital Agency (NASDAQ:AGNC) and Annaly Capital Management (NYSE:NLY) are set to report earnings in just a few short weeks.

After a terrible 2013, mortgage REITs could be set to take back some of the losses generated last year, when rapidly rising interest rates created a refinancing boom, and mortgage yields dipped.

NLY Total Return Price Chart

What's changed?
While the Fed continues to taper, longer-dated bonds are starting to settle into a reasonable trading range. In the last three months, interest rates on 30-year mortgages moved only modestly, rising as high as 4.54% and falling as low as 4.34%, according to BankRate.

This period of low volatility in mortgage rates is exactly the opposite of what we saw in 2013, when rates rocketed and Annaly Capital Management and American Capital Agency felt the pinch of falling prices for their portfolios of mortgage securities.

Going forward
Annaly Capital Management and American Capital Agency have their own distinct ways of riding out volatility in the mortgage market.

American Capital Agency has shifted its portfolio to a heavier weighting of 15-year securities. It believes it can generate higher returns with less volatility by holding 15-year mortgage-backed securities, which are less sensitive to interest rates than 30-year mortgages.

Meanwhile, Annaly Capital Management has continued to hold a majority (78.6%) of its agency holdings in 30-year mortgages. However, unlike American Capital Agency, Annaly Capital has been less aggressive with leverage, holding assets at 5:1 vs. 7.5:1.

Low volatility begets profitability
One of the biggest challenges of investing in mortgage-backed securities is knowing the future for interest rates. When interest rates rise, mortgage REITs experience fewer prepayments, but their book values decline with the drop in values for mortgage-backed securities.

When rates fall, mortgage REITs face declining profitability as higher-cost mortgages are refinanced at lower interest rates.

Thus, the best operating environment for mREITs is one like we see today -- where interest rates stay in a narrow band for many months at a time. It's in these calmer periods that interest rate spreads drive the bulk of quarterly earnings.

Assuming no big changes in either mREIT portfolio, capital gains or losses should be a relative non-factor in earnings reports this quarter. That sets the stage for a good quarter, one led by interest spread income, the key to big and sustainable dividend yields.

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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.

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