In the low interest environment that evolved from the Federal Reserve’s quantitative easing program, investors who were searching for higher yielding investments found them in mortgage real estate investment trusts or Mortgage REITs.
These funds that invest in mortgages secured by real estate will typically use leverage (or borrowed funds) to increase the amount of investable funds, sometimes to a level six to eight times its capital.
Leverage, or the use of borrowed funds, can be an extremely profitable tool when interest rates remain stable or decline. If you borrow at a low rate, invest at a higher rate and capture the spread it will workout very well.
For example if you can borrow at a cost of 1.5% while investing at a return of 4% earning the 2.5% spread, that represents a winning formula.
But, when interest rates begin to rise as they have recently with Fed tapering on the table, these investments can start to lose money unless a change of course is instituted by fund management. For example, imagine that you are now borrowing at 5% while earning a return of 4%. No one from the fund manager on down to the fund investors will be happy about that!
The speed and severity of any loss will be commensurate with the move in interest rates.
The takeaway from this is that investors need to closely monitor these types of interest rate sensitive funds and if they expect a further rise in mortgage rates consider either selling, or finding out what strategy the management of their fund is going to be implementing, if any, to deal with it!