FMY's Dividend Sustainability Amid Mortgage Market Volatility: A Delicate Balance

The First Trust Mortgage Income Fund (FMY) has long attracted income-seeking investors with its monthly dividends and focus on mortgage-backed securities (MBS). However, as interest rates climb and market volatility intensifies, the fund's ability to sustain its 7.57% annualized yield faces mounting scrutiny. This article evaluates FMY's dividend sustainability by dissecting its portfolio risks, hedging strategies, and management's guidance in a challenging macroeconomic environment.

The Yield Appeal: A High-Yield Proposition

FMY's 2025 dividend of $0.07 per share (6.67% of net asset value, 6.89% of market price) positions it as one of the more attractive options in the fixed-income space. The fund's portfolio, weighted toward longer-duration MBS with an average of 6.0 years, has historically generated consistent cash flows. In Q2 2025, newly acquired hedged positions even delivered mid-teens to low 20% returns on equity, underscoring the appeal of its strategy in a steepening yield curve.

Yet, this yield comes with caveats. A significant portion of FMY's distributions may derive from return of capital or capital gains, not just income. Investors must parse the tax implications and sustainability of these payouts, as the fund's 2025 distributions will only finalize their tax treatment on Form 1099-DIV.

Portfolio Risks in a Rising Rate Environment

MBS portfolios are inherently sensitive to interest rate movements. FMY's 6.0-year duration exposes it to two key risks:
1. Prepayment Risk: As rates rise, borrowers are less likely to refinance, locking in cash flows for longer periods. Conversely, a rate drop could trigger a surge in prepayments, reducing the fund's reinvestment yields.
2. Interest Rate Risk: A 1% increase in rates could erode the fund's net asset value by roughly 6%, given its duration profile. While FMY has reduced opportunistic CMBS exposure, its reliance on agency and non-agency MBS remains a vulnerability.

Hedging Strategies: Mitigating Volatility

FMY's management has taken a proactive approach to managing these risks. Treasury futures and derivatives are used to hedge duration and convexity, allowing the fund to extend or shorten its exposure based on market conditions. For example, in Q2 2025, FMY extended its duration in response to a steepening yield curve, capitalizing on higher long-end yields.

The fund's convexity management—adjusting the sensitivity of its duration to rate changes—has also been critical. By maintaining a longer duration than its benchmark, FMY aims to outperform in a rising rate environment while capping downside risk. However, the effectiveness of these strategies depends on the cost of hedging and the accuracy of rate forecasts.

Dividend Sustainability: A Strategic Reduction

In June 2025, FMY cut its monthly distribution from $0.075 to $0.07 per share, a 6.67% reduction. Management cited the need to align payouts with “current earning potential” and preserve capital amid economic uncertainty. This move reflects a pragmatic approach to sustainability: prioritizing long-term stability over short-term yield.

The fund's payout ratio—6.67% of NAV—suggests a healthy balance between income generation and capital preservation. However, this metric assumes steady net investment income. If mortgage spreads tighten or credit losses rise, FMY could face pressure to further adjust its dividend.

Investment Considerations

For investors, FMY represents a high-yield opportunity with clear risks. The fund's ability to sustain its dividend hinges on:
- Rate Stability: A prolonged period of rising rates could strain MBS valuations but might also boost reinvestment yields.
- Credit Quality: FMY's focus on high-quality MBS reduces default risk, but non-agency holdings remain a concern.
- Management Discipline: The fund's active hedging and duration adjustments demonstrate a commitment to risk management, though execution is key.

Conclusion: A Calculated Bet

FMY's 7.57% yield is tempting, but it demands a nuanced understanding of mortgage market dynamics. The fund's hedging strategies and strategic dividend reduction signal a focus on sustainability, yet investors must remain wary of rising rate volatility and prepayment risks. For those with a moderate risk tolerance and a long-term horizon, FMY could be a compelling addition to a diversified income portfolio—provided they monitor macroeconomic shifts and the fund's quarterly disclosures.

In a world where high yields come with high stakes, FMY's story is one of balancing act: leveraging mortgage market opportunities while navigating the turbulence of a shifting rate landscape.