With all the bad press they've been getting lately, you'd think "REIT" was a four-letter word. Since August, the NAREIT Index of all real estate investment trusts has fallen almost -6%. Mortgage trusts, a special breed of REITs that invest in loans backed by real estate, have done even worse. Mortgage REIT stocks are down a miserable -20% so far this year, according to the National Association of Real Estate Investment Trusts.

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What's the problem? 
Mortgage trusts thrive on cheap sources of capital, but when those sources dry up, profits shrink. No two trusts are exactly the same, but they all make money by borrowing at lower rates and reinvesting those funds at higher rates.

When short-term interest rates (two years or less) were much lower than longer-term rates (ten years or more), mortgage REITs could make easy money. All they had to do was borrow at lower short-term rates and reinvest the funds in long-term securities that delivered higher yields.

But that strategy hasn't worked too well this year, as short-term interest rates have moved higher but longer-term rates have remained fairly flat. Just 18 months ago, the gap between short-term and long-term rates (the difference between 2-year and 10-year Treasury notes) was more than 1.8% -- enough to turn a decent profit. Now that gap has narrowed to a five-year low of 0.8%.

Profits have been squeezed by this shrinking spread, and since mortgage REITs hand over most of their profits to shareholders, dividends have been slashed as well. Not surprisingly, shares of mortgage REITs have tumbled as a result. For example, industry leader Annaly Mortgage (NLY) cut its dividend in October for the third time in less than a year. The cut sent investors fleeing for the exit doors, driving the shares down -34% in a week.

Annaly is not alone. Of some 37 publicly traded mortgage REITs, at least seven have slashed their dividends an average of -25% in the past few months and have warned of additional cuts to come.

So why am I touting mortgage REITs?
No mortgage REIT is immune from the impact of rising interest rates. With this in mind, investor fears of further dividend cuts from these stocks have brought the entire sector to its knees. 

This is precisely why I'm recommending a few select stocks in this sector. I believe the sell-off has now created an excellent entry point for a handful of quality mortgage REITs. Although the overall sector has been hit hard, a handful of select mortgage REITs have survived and even thrived while rates were rising, and many of these stocks are now trading at bargain prices.

While other trusts were cutting their dividends, these firms were actually boosting theirs. The sharp drop in their share prices, coupled with the steep rise in their dividend payouts, has sent their yields to record territory. 

But maybe not for long. With the Fed likely nearing the end of its rate hike campaign, interest rates are leveling off and investors are starting to show renewed interest in mortgage REITs. Going forward, I expect the group to benefit from cheaper borrowing costs and steady profits.

As mortgage REITs continue to rebound, those firms that outperformed in the face of rising rates, like the ones featured below, should lead the charge.

Mortgage REITs bottomed in October and are starting to rally.

Here's a closer look at three of my favorite mortgage REITs . . .

Important Note:  Throughout the remainder of this article, editor Carla Pasternak provides a comprehensive table of all 37 domestic mortgage REITs, as well as an in-depth analysis of her three favorite stocks from this list. However, in order to view the remainder of this article, you'll need to subscribe to our premium income-oriented newsletter -- High-Yield Investing. After you subscribe you'll receive immediate access to this full article, as well as our monthly High-Yield Investing newsletter and a host of additional premium content. Please visit one of the following links to continue...

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