No Need to Bail on Mortgage Funds

Despite the recent slump, these funds are safe and usually offer better yields than Treasuries.
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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.

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

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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."