Mortgage REITs Outpace Business Development Companies Amid Shifting Rate Environment

Mortgage REITs Outperform as Interest Rates Shift

Mortgage Real Estate Investment Trusts (mREITs) have significantly outpaced Business Development Companies (BDCs) over the past year, marking a notable divergence in performance within the high-yield investment landscape. This trend is clearly observable through the VanEck Mortgage REIT Income ETF (MORT), which has demonstrably outperformed both the VanEck BDC Income ETF (BIZD) and the Putnam BDC Income ETF (PBDC) during this period. The primary drivers behind this shift include a favorable environment created by declining short-term interest rates for mREITs and heightened investor concerns regarding BDC loan defaults, exacerbated by recent corporate bankruptcies.

Divergent Performance Across High-Yield Sectors

The outperformance of MORT against its BDC counterparts has been substantial across various timeframes within the last 12 months. This divergence can be attributed to the inherent sensitivities of each sector to interest rate fluctuations and credit market conditions.

Mortgage REITs generally benefit from a gradual reduction in the Federal Funds Rate. Such declines can decrease their borrowing costs for repo financing, which is crucial for leveraged portfolios focusing on agency mortgage-backed securities (MBS). Companies like Annaly Capital Management, Inc. (NLY) and AGNC Investment Corp. (AGNC), significant players in the agency MBS space, are particularly sensitive to these rate changes. As interest rates fall, the value of their existing lower-yielding MBS holdings tends to climb, contributing to book value appreciation and improved cash flow. This easing of pressure follows a challenging period for mREITs characterized by an inverted yield curve and rising long-term rates.

Conversely, the BDC market, often viewed as a proxy for the $1.7 trillion private credit sector, has faced considerable headwinds. Rate cuts have squeezed payouts by reducing lending income from floating-rate loans and intensified competition from banks has further pressured lending spreads. This has led to a marked underperformance, with the BDC index lagging the S&P 500 by a wide margin in 2025. Specific publicly traded BDCs have experienced significant declines, with Blackstone Secured Lending Fund down approximately 21%, Blue Owl Capital Corp off 19%, and Ares Capital Corp lower by roughly 12%.

Impact of Rate Cuts and Credit Quality on BDCs

The adverse impact on BDCs has prompted managers to trim dividend distributions. For example, the Blackstone Private Credit Fund (BCRED), the industry’s largest BDC, cut its dividend by 9% last month—its first-ever reduction. Other firms, such as Oaktree Strategic Credit Fund and Golub Capital Private Credit Fund, have also reduced payouts by 10% and 15%, respectively. Analysts suggest that a 75-basis-point reduction in benchmark rates could translate into an 8–10% fall in total BDC dividends, given that dividend coverage ratios currently hover near 100%.

Adding to credit quality concerns, the September 2025 bankruptcy of First Brands Group, a major automotive parts supplier, has exposed critical vulnerabilities within the private credit and BDC sectors. With estimated liabilities between $10 billion and $50 billion, this event triggered a cascade of losses for institutional investors. The firm’s opaque financing structures, including $4 billion in shadow debt, masked unsustainable leverage. BDCs with significant exposure to such distressed debt face potential margin calls or forced liquidations, contributing to systemic risk concerns within the financial system.

Mortgage REITs Positioned for Improvement

In contrast, the outlook for mREITs appears increasingly positive. The easing of the inverted yield curve, where short-term borrowing costs exceeded long-term asset yields, combined with falling interest rates, is creating a more favorable operating environment. Annaly and AGNC Investment Corp., for instance, are showing positive momentum in their MBS values and anticipate reduced borrowing costs.

Current valuations for major mREITs reflect this optimism, with Annaly (NLY) estimated at a price-to-book value of approximately 1.08x and AGNC Investment Corp. (AGNC) at 1.23x, according to recent data. These figures indicate book value increases, suggesting a potential for greater returns through multiple expansion.

Industry experts corroborate this positive shift. Steve DeLaney of Citizens JMP notes:

"Within the mREIT industry, the largest positive impact will likely be seen in the commercial mREIT segment, where higher rates have increased the cost of carry for borrowers with floating-rate bridge loans and higher NOI capitalization rates have lowered real estate property valuations."

Jade Rahmani of Keefe, Bruyette & Woods adds that the Commercial Real Estate (CRE) environment is "set to improve in the fourth quarter and 2025" due to impending rate cuts. This improvement is expected to be driven by increased transaction volumes and attractive returns on new equity and debt investments, along with better financing markets.

Investment Considerations and Outlook

The contrasting fortunes of mREITs and BDCs present nuanced investment considerations. While the sustained outperformance of mREITs could attract further capital, driving valuations higher, BDCs may face continued pressure if credit quality concerns persist and the interest rate environment remains challenging for their business model. The Federal Reserve's future interest rate decisions will remain a critical determinant for both sectors in the short to medium term.

For investors seeking stability, particularly in a volatile market, preferred shares and baby bonds in both sectors offer attractive yields (typically 9-10%) with significantly less volatility than common shares. While some analysts suggest opportunities in carefully selected BDCs following their price declines, caution is advised when chasing high dividend yields in common shares of mREITs like AGNC, ARMOUR Residential (ARR), or Orchid Island Capital (ORC). Their strong earnings may be temporary, influenced by expiring interest rate swaps, which could lead to declining net interest spreads and reduced dividend coverage ratios. A discerning approach, focusing on underlying fundamentals and the sustainability of payouts, is essential.