Mortgage REIT story updated from 9:35 a.m. to include Thursday's price action in final paragraph.

NEW YORK (

TheStreet

) -- Rising interest rates have sparked a selloff in mortgage REITs, but reports from Keefe Bruyette & Woods and RBC Capital Markets urge investors to use the opportunity to add exposure to the sector.

"We think the bond market has over-reacted and mortgage REITs have over-reacted to that over-reaction. We maintain our positive outlook," states one of two reports on mortgage REITs from KBW Wednesday.

Ten-year Treasury yields have gone from 1.61% on May 1 to 2.13% ahead of U.S. stock markets opening Thursday. Two-year yields, meanwhile, have risen to 0.30% from 0.20%.

The business model of many mortgage REITs is to fund themselves for short periods of time and then, using leverage, buy longer-dated mortgage-backed securities and debt issued by U.S. agencies such as

Fannie Mae

and

Freddie Mac

. But when bonds sell off, it creates a problem for the REITs since their funding costs rise while the value of the securities they hold declines.

The selloff in Treasuries has been driven by fears the U.S. Federal Reserve will begin tapering its monthly purchase of U.S. Treasury bonds and mortgage backed securities.

Also see: Short Sales Decline Amid Rising Home Prices: RealtyTrac >>

Stocks with less downside potential if the Fed cuts back its stimulus more quickly than expected, according to KBW, are

Capstead Mortgage Corp.

(CMO) - Get Report

,

Hatteras Financial

(HTS)

,

MFA Financial

(MFA) - Get Report

,

Anworth Mortgage Asset

(ANH) - Get Report

, and

Dynex Capital

(DNX)

.

However, investors who expect Fed stimulus to continue longer should focus on stocks that have been hardest hit by the recent bond market selloff. Those include

American Capital Agency

(AGNC) - Get Report

,

American Capital Mortgage Investment

(MTGE)

, and

Western Asset Mortgage Capital Corp.

(WMC) - Get Report

.

RBC recommends

Annaly Capital

(NLY) - Get Report

as well as MFA and Hatteras. They also recommend American Capital Agency, though they warn that "higher leverage in its business magnifies returns and losses as well."

The bullish reports, as well as a stabilization in Treasury yields appeared to have a positive affect on the mortgage REIT sector Thursday as several names were positive going into the final hour of trading. AGNC was up 1.46% to $26.79, Capstead was higher by 2.53% to $12.55, MFA was up 0.96% to $8.89 and Anworth was up 2.15% to $5.71. Annaly, however, was down 0.75% to $13.88.

--

Written by Dan Freed in New York

.

Follow @dan_freed

Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.