No Need to Bail on Mortgage Funds

Since prepayment risk is greatest when rates are falling, and extension risk occurs when rates are likely to rise, it's common sense to think the two don't happen in tandem. But nothing in today's market is subject to common sense. "Nobody in the mortgage market is clear on what's going on. Fund managers have been stymied over whether to hedge for prepayment risk or extension risk," Clark says. "So they've been hedging both, and that gets expensive."

And that expense diminishes a fund's return.

The refinancing boom has wreaked havoc with managers trying to manage prepayment risk. Not only did the low-and-getting-ever-lower rates of the past few years fuel the boom, but lenders also removed other obstacles to refinancing. Historically, lenders charged at least a point or two (an upfront fee that amounts to 1% of the loan amount) in the refinancing arrangement. Today, though, lenders rarely charge points.

Meanwhile, interest rates are at 40-year lows and aren't expected to drop any further; this leads to speculation about when they might increase, and that leads to extension risk.

"We're in brand new territory when it comes to hedging," Clark says. "But if rates trough, mortgage funds should begin to perform better."

With mortgage rates around 5.5% to 6%, mortgage funds should be returning 1.25% to 1.5%, Clark says. But the past quarter the average mortgage fund returned just 65 basis points, or 0.65%.

With the refinancing boom slowing down and rates likely to stay put, though, mortgage funds will recover -- but not immediately. "In 1994, there was a slump and in 1999, there was a slump," says Scott Berry, an analyst with Morningstar. "But they bounced back pretty quickly in each of those years."

In the meantime, Berry says, it's especially important to keep an eye on fund expenses. Vanguard's (VFIIX Quote)GNMA fund is a particularly good choice. "It's almost a pure play on mortgages," Berry says. "And it's cheap, which gives it a definite sustainable advantage over most other funds."