Mortgage-backed securities ride strong housing market

Call it a vote for the stability of the US housing sector or a protest against the troubled US stock market. Either way, investors continue to pour money into bond funds, especially those that hold government-backed mortgage securities.

For the week ending Aug. 21 alone, inflows to taxable bond funds hit $1.4 billion, with more than half that amount going to mortgage-backed funds, according to AMG Data Services, which tracks mutual-fund flows. For the year, more than $16 billion has flowed into mortgage-backed funds.

In terms of gains, funds that specialize in mortgage-backed securities, especially Ginnie Mae funds, have been among the high achievers for 2002, and there is no indication of a major dropoff for the remainder of the year.

Yet, many investors find these funds somehow confusing or stodgy.

Brandishing individual securities issued by US mortgage agencies popularly known as Ginnie Mae, Fannie Mae, and Freddie Mac, mortgage-backed-securities funds are among the safest or, at the least, durable, of all fixed-income funds.

The top 25 mortgage-backed bond funds have posted average gains of about 6 percent for the year through Aug. 27, according to analysis by information firm Morningstar Inc., in Chicago. (See chart, below.) Compare that with the Standard & Poor's 500 Index, which is down some 17 percent, or the loss of some 11 percent in the Dow Jones Industrial Average.

And while the biggest mutual-fund gainers of 2002 have begun to show signs of slippage – real estate funds (REITs) and gold funds, for example – mortgage-backed bond funds continue to eke out modest but clear gains.

"We were quite surprised at how well the funds did in July and August," says David Ballantine, managing director of Payden & Rygel, a mutual-fund company in Los Angeles. Payden & Rygel's GNMA Fund, with assets of about $135 million, is up about 7 percent so far this year.

"We had thought that there would be some dropoff in the summer," Mr. Ballantine says, "but that hasn't happened."

Mortgage-backed funds invest in securities sold by the key US housing agencies. The agency best known as Ginnie Mae, for example (from the acronym GNMA, for Government National Mortgage Association), is a government corporation that provides liquidity for low- and moderate-income and first-time homeowners. Fannie Mae and Freddie Mac are other government-sponsored homeowner programs.

These quasi-governmental agencies buy individual mortgages from banks and other lenders and then package them as investment pools. Mutual-fund companies then create funds that invest in these pools.

Government-backed mortgage securities carry roughly the same credit quality as US Treasury issues. In the case of GNMAs, the securities carry the same explicit federal-government guarantee on principal and interest as US Treasury bonds. Fannie Mae and Freddie Mac securities carry an implicit government guarantee, slightly less than for GNMAs.

So far this year, GNMA obligations have yielded between 1 and 2 percent more than Treasury bonds of the same maturity, because of uncertainties hovering over the mortgage market. If interest rates were to rise, homeowners would presumably hang on to their current mortgages. If rates drop, the same homeowners may be tempted to refinance.

Refinancing activity is almost certain to mitigate some of the future gains of GNMA funds, but not enough to derail continued gains for 2002, Ballantine says.

Scott Berry, who tracks mortgage-backed securities for Morningstar, agrees. While mortgage refinancing and higher interest rates could weigh on future gains, he maintains, the negatives will not be enough to unravel their solid run for the remainder of 2002.

Mr. Berry says investors can use a GNMA fund as a "core" bond holding, instead of a corporate bond fund, or a US Treasury fund. Over the past five years, for example, mortgage-backed funds have slightly outperformed Treasury bond funds.

Mortgage-backed funds that Berry likes include GNMA funds offered by Vanguard, T. Rowe Price, Franklin, and Fidelity.

In shopping for a mortgage-backed bond fund, look for lowest possible expense ratios, he says, which means a fund with a ratio of about 0.6 percent or lower.

Despite their strong performance this year – or precisely because of it – mortgage-backed securities funds have left some analysts wary of their future performance.

Jim Lowell, who tracks Fidelity funds through his "Fidelity Investor" newsletter, urges his clients to avoid these funds now, given the continued risk of interest-rates cuts and the likelihood of increased refinancing.

Although the funds have almost no credit risk, he says, the danger of interest rate changes outweigh the slightly higher yields that mortgage funds provide over Treasury bonds.

Still, Fidelity's GNMA fund is up more than 5 percent for the year, and gained more than 1 percent in July.

Fidelity's Mortgage Securities Fund is also up over 5 percent for 2002. Among taxable bond funds, only Fidelity's government bond funds have posted similar results.