Mutual Funds Investing in Unloved Mortgage Bonds Are Soaring

Friedlander argues that the securities are priced as if the housing markets will remain deeply depressed. But the outlook has been improving as the inventory of foreclosed homes has shrunk. According to Standard & Poor's Case-Shiller index, home prices have increased for the last three months -- a big change from earlier in the year when prices were falling.

TCW Total Return has 34% of its assets in nonagency mortgages. Portfolio manager Bryan Whalen argues that the securities will continue performing well because supplies are declining at a time when demand is growing.

During the boom years of 2004 through 2007, investment banks issued $1 trillion in nonagency securities. Then the market froze as panicked investors refused to make any more commitments.

Since the financial crisis, only a trickle of nonagency securities has appeared.

"The private markets have not been willing to buy mortgages, unless they are guaranteed by the government," says Whalen.

With few new issues, the total amount of nonagency mortgages has declined as borrowers paid off loans. While supplies have dwindled, demand has increased as investors have become less concerned about defaults.

Besides loans made to owners of single-family homes, some funds also invest in commercial mortgages that finance properties such as office buildings and hotels. The commercial mortgages have provided a boost for Virtus Multi-Sector Fixed Income (NAMFX), which has returned 11.3% this year.

Portfolio manager Andrew Szabo says that the outlook for commercial properties is improving. Vacancy rates for office buildings and hotels are heading down, and few properties are defaulting.

Investors have been flocking to the commercial securities because triple-A-rated mortgages yield 2.8%. While demand for space is slowly growing, only limited supplies are becoming available.

"Occupancy rates have been improving, because there has not been much construction nationwide," says Szabo.

At the time of publication, Luxenberg held no positions in funds mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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