A Steepening Yield Curve Is Music to Mortgage REITs

After years dealing with an inverted yield curve for the bond market, the current backdrop for Treasury yields has normalized, which is bullish for specific asset classes, including mortgage REITs ( mREITs).

A yield curve that steepens shows a wider spread between short-term and long-term yields. The U.S. Treasury yield curve is steepening because the Federal Reserve is cutting short-term rates, while long-term yields are rising due to persistent inflation concerns, heavy Treasury issuance and stronger-than-expected economic data. Last week’s rate cut by the Fed saw short-term yields decline, while long-term yields rose.

Other factors weighing on the long end of the yield curve include a heavy Treasury auction calendar in mid-December, along with large issuance of 10- and 30-year bonds, which reflect a market that believes the Fed won’t cut aggressively in 2026 and that holding long-duration debt requires a bigger premium.

From copilot.com.

A steepening yield curve is generally bullish for mortgage REITs, as they borrow short-term at lower rates and invest in longer-term mortgage-backed securities (MBS) with higher yields. The widening spread boosts net interest margins and dividend potential, although risks like prepayments and volatility remain.

With higher spreads, mREITs can sustain or increase dividends, since they must distribute 90% of taxable income to shareholders. Also, existing MBS portfolios often rise in value during a steepening, boosting book value per share.

While the chart of Annaly and other mREITs are constructive, there are always inherent risks with this asset class. mREITs borrow short-term to buy long-term mortgage-backed securities. Compared to equity REITs, mREITs are more sensitive to interest rate volatility, funding spreads and prepayment dynamics.

If repo/funding costs stay high, spreads compress. Because mREITs invest in 30-year mortgages, rising long-term yields reduce the market value of MBS holdings, eroding book value. High dividends attract investors, but payouts depend on stable spreads and book value. And faster prepayments reduce income.

Investing in mREITs tends to be an asset class that is “rented” and not owned for extended periods of time. Presently, the wind is at the back of the sector, which includes 41 listed mREITs with a combined market cap of around $77.4 billion. The top five mREITs have total market cap of $43.5 billion, reflecting a concentrated weighting. The weighted average yield is 11.5%, reflecting its income-focused model.

The bullish case for mREITs now rests on further potential falling short-term funding costs via Fed rate cuts, resilient to higher dividends, and the potential for spread expansion as the yield curve normalizes. The yield curve has normalized, with the 2/10 year spread back in positive territory, and moderating rates plus steady growth, historically a supportive environment for housing finance and MBS demand.

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