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Unlike last year, 2014 has seen a pretty decent performance from the mortgage REIT sector. Contrary to the popular belief that escalation of Fed taper will result in rising rates, interest rates have actually moved in the opposite direction.

Thanks to lackluster economic data, weak U.S. equity markets, geo-political crises and an emerging market lull during the first quarter of the year, risk adverse investors used U.S. government debt as a flight to safety. This pushed yields southwards, working favorably for mortgage REITs, which have performed decently since the start of the year (read: 3 ETF Winners from Earnings Season).

However, this time around companies are reporting narrower spread margins primarily due to lower long-term yields. Mortgage REIT companies borrow short-term debt and then use this capital to buy longer-term mortgage securities. Hence a wide (and stable) spread between the short and long term is crucial for their success.

However, both Annaly Capital Management Inc. (NLY - Free Report) and American Capital Agency Corp (AGNC - Free Report) have reported declining net interest income for the first quarter of 2014. However, what was noteworthy was that the erosion in the book value per share for both these companies has come to a halt, at least for the time being (read: 3 Long Term Bond ETFs Surging as Rates Stay Low).

NLY in Focus

Annaly Capital Management missed the Zacks Consensus Estimate of 27 cents a share, earning just 23 cents a share instead. This compares unfavorably both with the previous quarter and the year-ago quarter.

Spread compression during the quarter due to lower long-term yields, adversely impacted the company’s net interest income, which dropped 16.2% sequentially and 5.1% year over year (read: 3 Sector ETFs Braving the Market Slump).

Following the weak earnings results, NLY’s shares dropped roughly 3%, but recovered 0.96% during the next trading day. A sequential rise in the company’s book value per share and a year-over-year fall in leverage during the reported quarter seem to have given some relief to investors.

AGNC in Focus

AGNC on the other hand reported encouraging first-quarter 2014 results with adjusted income per share comfortably beating the Zacks Consensus Estimate of 68 cents.

Concerted efforts towards portfolio repositioning and shrinking its capital base by share repurchases enabled the company to post impressive numbers. However, the company reported a drop in net interest income from the preceding quarter.

ETF Impact

Despite the earnings miss by NLY, Mortgage REIT ETFs that have huge exposure to the company were unaffected delivering flat performance over the past few trading sessions. In fact, these funds have gained modestly in the past two weeks following strong earnings by AGNC (see all the Real Estate ETFs here).

iShares Mortgage Real Estate Capped ETF (REM - Free Report)

REM tracks the FTSE NAREIT All Mortgage Capped Index, measuring the performance of the residential and commercial mREIT market in the U.S. The fund consists of 36 securities in its basket while it charges investors 48 basis points a year in fees.

NLY and AGNC are the top two holdings of the firm occupying 15.22% and 11.25% share respectively. This suggests huge concentration of fund assets among the top 10 holdings, with nearly two-thirds of assets going to the top 10 securities alone.

The fund has added 0.73% in the past one week and is up 12% since the start of the year. Also, the product has a tremendous yield of nearly 15.61%. So it is suitable for investors seeking maximization of current income, though brave enough to bear volatility.

Market Vectors REIT Income ETF (MORT - Free Report)

NLY and AGNC occupy the top two spots here too, having a combined exposure of roughly 30%. 

The fund is relatively less popular with an asset base of $106.2 million and expenses of 40 basis points a year. The fund tracks the Market Vectors Global Mortgage REITs Index, measuring the performance of companies primarily engaged in the purchase or service of commercial or residential mortgage loans.

The fund has gained roughly 0.95% in the past one week and 12.4% in the year-to-date time frame. However, it has a lower dividend yield of 9.65% as compared to REM.

Bottom Line

Though investors luckily evaded a volatile performance from the above ETFs following the earnings release of NLY and AGNC, they should nevertheless play these ETFs with caution.

Any rise in short-term yields would adversely affect their performance. A jump in rates would force REITs to pay higher amounts to borrow money which in turn would impact their dividend yields, and could be the catalyst for a drop in these ETFs.

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