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No Need to Bail on Mortgage Funds

This article originally appeared in The Save Safe Plan newsletter. For more information on this product, please click here.

While interest rates steadily plummeted over the past three years, homeowners have rejoiced. Indeed, many seem to have exuberantly taken up refinancing their mortgages as an amusing new hobby. (You know who you are.)

But while today's super-low mortgage rates (the national average is 5.6%, according to ) are a boon to homeowners, investors in mortgage-backed securities have little to cheer.

Typically, lower interest rates benefit mortgage funds. As mortgage rates drop in concert with interest rates, the mortgages the funds already hold pay a higher yield than the newer mortgages. But mortgage funds -- usually a better bet than Treasuries -- posted a measly 2.1% in the first six months this year, while long-term Treasury funds have fared more than twice as well, returning an average 5.7%, according to Morningstar.

But while this somewhat startling trend isn't likely to turn around in the next six months, there's no reason to bail on mortgage funds. "If you're looking for an extra kick to your portfolio in the next three to six months, you're probably not going to get it from mortgage funds," says Andrew Clark, a senior research analyst with Lipper, a Reuters company. "But if you're holding a mortgage fund, you don't need to get rid of it. They're still relatively safe, and their yields beat Treasuries. Those are two really good reasons to hold these funds for the long term."

Mortgage funds generally present higher returns than Treasuries because of the moderately higher risk. There's prepayment risk, which occurs when homeowners pay off their higher rate loans with new loans at a lower rate (i.e., refinancing). And then there's extension risk, which happens as interest rates rise and the bulk of the mortgages that a fund holds yields less than the higher-rate mortgages being issued.
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