Appearances can be deceiving. While on the surface everything these days seems to be moving along without a hitch, there is a huge underlying force steering the U.S. economy. 

I am not talking about a dark and evil conspiracy plotting to overthrow the government. The force I am talking about is much more mundane — yet it is more powerful than any political movement. In fact, it takes billions of dollars each day to put the reins on the world’s most powerful economic control mechanism.#-ad_banner-#

This vast force is better known as interest rates. 

Sorry to disappoint anyone hoping for a revelation here, but the power of interest rates is beyond any need to exaggerate. Stock prices, economic growth, and even the rise and fall of empires can be tied to the interest-rate equation.

Stock investors feel the effects of interest rates every day in their portfolio. The old rhyming maxim “When rates are low, stocks will grow; when rates are high, stocks will die” couldn’t be more accurate. The extreme bull market we have witnessed over the past several years is directly tied to ultra-low interest rates. However, there is a big change brewing just under the economy’s surface.

Interest rates are starting to creep higher, and the stock rally is slowing. The first stock investors to directly feel the negative effects of rising interest rates are those who hold instruments directly tied to rates, such as mortgage real estate investment trusts (known as mortgage REITs or mREITs).

These formerly top-performing dividend machines have been smacked lower since rates started inching up in May. Favorites such as Annaly (NYSE: NLY) and American Capital (NYSE: AGNC) are trading lower by 25% and 20%, respectively. On average, mortgage REITs are down by more than 18% on the year.

The reason for this is that REITs need to borrow money to increase their assets. Therefore, any small decline in asset values can have a multiplicative effect on their equity. When interest rates are stable, mortgage REITs outperform Treasurys. The opposite also holds true: Mortgage REITs underperform in an environment of rising interest rates. This is known as convexity, and simply put, convexity risk is what has knocked the mortgage REITs down.

Fortunately, not all mortgage REIT stocks have been punished to the extent that American Capital Group and Annaly have. The primary reason is that both those mortgage REITs are built on fixed-interest rates. Simply, fixed-rate mortgage REITs are more affected by climbing interest rates than their adjustable-rate and hybrid peers. 

This has to do with the way adjustable-rate mortgage and hybrid REITs are leveraged. For example, hybrid REITs are leveraged, on average, just three to six times; compared this with fixed REITs, which are leveraged at six to nine times. 

Let’s take a closer look at an adjustable-rate mortgage REIT and a hybrid mortgage REIT.

Source: WolframAlpha

Capstead Mortgage (NYSE: CMO)
This adjustable-rate mortgage REIT is trading higher by nearly 10% this year. It pays an annual dividend of $1.68, which equals a 10.8% yield. 

MFA Financial (NYSE: MFA)
This is a hybrid mortgage REIT consisting of both adjustable and regular mortgages. It is trading higher by nearly 10% on the year but is off by 3% over the past few weeks. Yielding nearly 17% with an annual dividend of $1.58, this hybrid REIT is a top performer.

Risks to Consider: During the past week, all mortgage REITs have bounced higher on stabilizing interest rate speculation. Although adjustable-rate and hybrid mortgage REITs have a much higher tolerance for rising rates than fixed-rate mortgage REITs, most mortgage REITs are negatively affected by rising rates. With the rates so low, it is only a matter of time until they start rising again. Use caution in this sector because the high yields mean equally high risk.

Action to Take –> The mortgage REIT sector is extremely attractive due to the higher than normal yields thrown off by these stocks. If you believe higher interest rates are inevitable, avoiding the standard fixed-rate agency mortgage REITs makes sense for everyone but short-term traders. However, longer-term investors can gain protection from rising interest rates but still retain exposure to the high-yielding sector by investing in hybrid or adjustable-rate mortgage REITs. I still see opportunity for longer-term investors in adjustable-rate and hybrid REITs despite the inevitability of interest rate increases.

P.S. — If you are impressed by the high yields offered by these REITs, you should learn about a special group of dividend growers beating the market 7-to-1. We call them “rich parents” stocks, because they all have a wealthy “parent” company giving them sweetheart deals and special pricing. A $10,000 investment in one of these stocks in 2001 would be worth $177,200 today, but thanks to their rich parent advantage, that looks like just the beginning. To get the names of some of these stocks, click here.