Navigating the Risk-Off Landscape: Mortgage REITs as a Tactical Hedge in Q2 2025

In Q2 2025, the U.S. capital flow landscape was shaped by a dramatic interplay of policy uncertainty, geopolitical tensions, and investor sentiment shifts. The "Liberation Day" tariff announcements in early April triggered a sharp selloff, sending the S&P 500 into bear market territory and spiking the VIX to pandemic-era levels. Yet, as trade negotiations progressed and the Fed maintained a cautious stance, markets rebounded, with the S&P 500 gaining 10.5% by quarter-end. Amid this volatility, defensive strategies and alternative assets emerged as critical tools for portfolio resilience.

U.S. Net Capital Flows: A Tale of Resilience and Rebalancing

The U.S. recorded a net capital and financial account surplus of $77.8 billion in June 2025, driven by $70.5 billion in net foreign official inflows and $7.3 billion in private inflows. Foreign investors increased holdings of U.S. long-term securities by $192.3 billion, while U.S. residents added $41.5 billion to foreign assets. This dynamic reflects the enduring appeal of U.S. equities, which delivered +11% returns in Q2, despite initial risk-off panic.

However, the inflows were not uniform. ETF flows revealed a strategic repositioning: the iShares Core S&P 500 ETF (IVV) attracted $14.25 billion, while the Vanguard S&P 500 ETF (VOO) faced outflows of $5.49 billion. Investors sought diversification, with European ETFs like the Wisdom Tree European Defence UCITS ETF (WDEF) drawing $21.3 billion. This shift underscores a broader trend: capital flows are increasingly sensitive to macroeconomic signals and policy-driven uncertainty.

Mortgage REITs: A Defensive Counterpoint in a Volatile Environment

Amid the risk-off environment, Mortgage REITs (mREITs) emerged as a tactical hedge for investors seeking yield and diversification. While traditional fixed-income assets faced challenges in a rising rate and inflationary climate, select mREITs demonstrated resilience through active management and strategic leverage.

Blackstone Mortgage Trust, Inc. (BXMT), for instance, leveraged its sponsorship by Blackstone Inc. and a liquid balance sheet to capitalize on real estate credit opportunities in North America and Europe. Despite broader market turbulence, the Baron Real Estate Income Strategy continued acquiring shares in BXMT, citing its access to a global pipeline of commercial real estate assets and strong management. Historical data from 2022 to 2025 shows BXMT has a 57.14% win rate in 3-day returns following earnings releases, with an average 3-day gain of 0.03%. This suggests a consistent short-term positive reaction to earnings events, though longer-term volatility remains mixed.

Conversely, Two Harbors Investment (TWO) faced headwinds in Q2, with a $199.9 million litigation charge and a 111% revenue decline. Yet, its dynamic portfolio and focus on technology-driven efficiency improvements—such as AI in servicing and origination—highlighted its potential to adapt to volatile conditions. Management emphasized the importance of rate cuts and RMBS spread normalization in unlocking future returns. Backtesting from 2022 to 2025, however, reveals a weaker post-earnings performance for TWO: a 28.57% 3-day win rate and an average 3-day return of 0.00%, with a maximum gain of 0.14% observed on day 5. These results underscore the stock's heightened sensitivity to short-term shocks and operational risks.

Strategic Considerations for Investors

1. Balance Sheet Strength: Mortgage REITs with robust liquidity and low debt-to-equity ratios (e.g., BXMT's 7x leverage) are better positioned to weather market stress. BXMT's historical post-earnings resilience (57.14% 3-day win rate) highlights the value of disciplined leverage and active management.
2. Active Management: Firms like Two Harbors, which prioritize technology and operational efficiency, can mitigate risks from prepayment volatility and funding costs. However, TWO's mixed backtest results (28.57% 3-day win rate) suggest that even strong operational strategies may struggle to offset external shocks.
3. Diversification: Combining mREITs with international equities and core bonds can reduce portfolio correlation to U.S. market swings.

Conclusion: Hedging in a Fragmented Market

The Q2 2025 experience underscores the importance of defensive positioning in a risk-off environment. While Mortgage REITs are not immune to volatility, their ability to generate income, hedge against inflation, and adapt to policy shifts makes them a compelling tactical asset. Investors should prioritize mREITs with strong governance, diversified portfolios, and proactive risk management—qualities that align with the evolving demands of a capital flow-driven market.

As the Fed navigates inflation and trade policy uncertainties, Mortgage REITs may offer a unique blend of yield and resilience, serving as a counterbalance to the ebb and flow of global capital.