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The recent rise in long-term interest rates is an early sign that better times are ahead for the group of specialty finance companies known as mortgage real estate investment trusts. 

By their nature, real estate investment trusts, or REITs, are interest-rate sensitive, given their reliance on debt-funded property purchases. Mortgage REITS are different than regular real estate investment trusts in that they buy securities backed by assets, rather than actual properties. Most of the time, mortgage REITs buy and hold the securities issued by quasi-government agencies Fannie Mae, Freddie Mac, and Ginnie Mae. Among the group, Annaly Capital (NLY) is by far the largest. Capstead Mortgage (CMO); American Capital Mortgage (MTGE); American Capital Agency (AGNC); Dynex Capital (DX); Apollo Residential (AMTG), and Hatteras Financial (HTS) are competitors.

The business of mortgage REITs is similar to that of lenders, in that their fortunes are determined by the spread between asset yields and funding costs. The difference is that mortgage REITs usually don’t make loans directly, but rather purchase the aforementioned government-agency securities. And if a mortgage REIT only invests in government-agency securities, and avoids dropping a notch in quality to buy what are referred to as private-label securities, credit risk is minimized.

These days funding costs are extremely low, since they are tied to the short-term interest rates set by the Federal Reserve. But the subsequent fall in asset yields over the past few years has made spreads less attractive than when funding costs first started to drop.

The good news is that the trend in asset yields appears as if it has started to reverse course, given the backup in bond yields over the past few months. That has lifted mortgage rates from their lows. The rate on a 30-year mortgage was at a record low of around 3.5% last December, but has since risen by more than a full percentage point, on average. That is beginning to lift interest-rate spreads, and tentatively improve margins for the group.

Still, mortgage REITs tend to do best when funding costs are falling, since profits rise as asset yields fall more slowly. So, it would seem that another cycle of short-term rate increases by the Fed, to a new equilibrium prior to the central bank easing policy again, would need to take place before the optimal time to invest in mortgage REITs materializes.

Moreover, the Fed has indicated that it is still a long way from starting to raise interest rates. Before it gets to that point, the central bank needs to slow, and eventually end, its asset-purchase program, otherwise known as quantitative easing. Lately, there has been much debate over when the Fed will start to pull back on its bond buying, which has entailed the monthly purchase of $40 billion of mortgage-backed securities and $45 billion of U.S. Treasury securities. Indications are that such tapering will begin by the end of 2013. But a subsequent rise in short-term interest rates might not begin until 2015, or even 2016.

However, there could be a trading opportunity in mortgage REIT stocks, if margins widen as longer term interest rates rise, but before it begins to appear as if short-term interest rates will move up. Less nimble investors can always wait for an even better time to take a position in a mortgage REIT, after the interest rate cycle evolves and short-term rates fall, but that is likely a few years away yet.

At the time of this article, the author did not have positions in any of the companies mentioned.