Getting Fatter Yields With Mortgage ETFs

New York (TheStreet) -- Struggling to find more income, investors have been pouring into high-yield bonds, which yield 6% or more. That's a nice payout at a time when 7-year Treasuries yield 1.03%.

But high-yield bonds come with plenty of risk. If the economy slips, the bonds could sink. To pick up a bit of extra yield without taking on much risk, consider mortgage exchange-traded funds.

A popular choice is iShares Barclays MBS Bond (MBB), which yields 2.36%. Other funds that yield a bit more than comparable Treasuries include SPDR Barclays Capital Mortgage Backed Bond (MBG) and Vanguard Mortgage-Backed Securities Index ETF (VMBS).

In normal times, mortgage securities come with important risks. If interest rates swing sharply, the securities can suffer losses. But the current mortgage market is hardly normal. Trying to stimulate the economy with its third round of quantitative easing, the Federal Reserve has been buying $40 billion of mortgages each month. That has made mortgage ETFs safer. As long as the Fed keeps buying, mortgage prices are not likely to drop suddenly.

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What happens when the Fed stops buying mortgages and begins raising interest rates? Mortgages can sink sharply when rates rise, warns Mark Egan, portfolio manager of Scout Core Bond (SCCYX), a mutual fund.

As recently as February 2011, rates on 10-year Treasuries topped 3.60% before dropping to today's level of 1.61%. Egan worries that rates could swing sharply back to their former levels.

"If rates go back to 4%, a lot of investors would be shocked by the price declines of mortgages securities," he says.

Fed Chairman Ben Bernanke has said that he plans to hold down rates for the next several years. But Egan cautions that the central bank could change course suddenly. If the economy starts rebounding 18 months from now, the Fed could raise rates sharply.

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Still, it seems unlikely that the Fed will increase rates for the next year or so. That should provide an ideal market environment for mortgage ETFs, which tend to outperform Treasuries during periods of flat or slightly rising rates.

The funds hold a variety of mortgage-backed securities that are sponsored by agencies such as Fannie Mae (FNMA) and Freddie Mac (FMCC).

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