The securities represent pools of home mortgages. As homeowners pay principal and interest, the cash is passed along to investors in the securities. Some of the agencies nearly collapsed during the financial crisis. But they were taken over by Washington. As a result, the mortgage securities now have negligible default risk.
Although they cannot default, the mortgages provide extra yield because they come with the risk of prepayments. These occur when homeowners refinance or sell homes and pay off mortgages.
In the event of a prepayment, investors receive their principal back and must reinvest it at prevailing rates. Prepayments can be damaging during periods of sharply falling rates.
To appreciate the hazard, consider a mortgage security that yields 6%. Now rates drop. Homeowners refinance and take on mortgages that yield 4%. As a result, funds are left holding low-yielding assets. In comparison, holders of Treasuries have greater certainty because their bonds always pay a fixed rate. For the moment, prepayment risk seems limited because interest rates seem to be hitting rock-bottom levels. To get some extra yield, try iShares Barclays CMBS Bond (CMBS), which yields 4.38%. The fund invests in mortgages of commercial properties, such as office buildings. But commercial mortgages can be risky because they are not insured by government agencies, cautions Timothy Strauts, a Morningstar ETF analyst. Although agency mortgages carry Standard & Poor's top rating of AAA, the commercial mortgage fund only has a rating of A-. "If we go into a recession, commercial mortgages could be hurt," cautions Strauts. At the time of publication, Luxenberg had no positions in funds mentioned. Follow @StanLuxenberg This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.