Mortgage-Backed Bonds’ Prices Have Been Tumbling : Securities: Low interest rates prompt home owners to refinance. This leads to early redemption of bonds.

A welcome trend for homeowners is giving investors in mortgage-backed securities a case of heartburn.

Spurred by last month’s drop in mortgage rates to the lowest levels in 19 years, Americans are rushing to refinance, taking out new low-interest home loans to prepay old mortgages.

The savings can be substantial. By trading in a 30-year fixed-mortgage loan at 10% for an 8% one, the average homeowner saves $200 a month on a $100,000 loan, not counting extra refinancing costs.

But for owners of mortgage-backed bonds, the prepayments spell trouble. When a homeowner prepays a mortgage, investors in the securities that finance the loans get back their principals prior to maturity--and are forced to reinvest at today’s lower interest rates.

The result is that investors fearing an unexpected return of principal have been dumping their mortgage-backed securities, flooding the market with excess supply and driving down prices.

The decline in mortgage-backed bond prices is even more precipitous than in the previous rush to pay off mortgages early this year, just after the Federal Reserve lowered short-term interest rates in December. The most recent Fed easing was July 2.

“There seems to be a mad rush for the exits this time around,” said Gregg Patruno, vice president in fixed-income securities at First Boston Corp.

Back in January, many bond investors underestimated the volume of mortgage prepayments and were stuck holding the securities when the actual flood occurred in the spring, said Patruno. The worst hit have been derivative mortgage securities called “interest-only” strips, which separate interest and principal payments generated by pools of home mortgages. Investors in these bonds earn only the interest on home mortgages backing their securities.

Prices of these securities plummeted 30% in July alone--one of their biggest one-month drops ever.

The sharp decline isn’t that surprising considering how risky the securities can be. When homeowners pay back their loans early, all interest payments to the investors disappear, and holders lose their investment.

For investors in mutual funds, the plunging prices of mortgage-backed bonds can mean negative returns at a time when other bond funds are soaring.

Hurt the most have been funds invested in adjustable-rate mortgages, which typically include more interest-only strips to help boost returns. The worst performing fund in this category was the Ranieri Adjustable Rate U.S. Government II fund, which lost 0.80% in July, said Morningstar Inc., a Chicago research firm that tracks mutual funds.

Losses were lower for funds invested in fixed mortgages, which generally include fewer interest-only strips.

Three of these mortgage-backed funds had negative returns in July, said Morningstar: Fidelity Mortgage Securities lost 0.23%, Fidelity Spartan Ginnie Mae was down 0.13%, and Cardinal Government Obligations lost 0.11%.

In contrast, the average Treasury fund was up 3.3% in July, boosted by falling interest rates that made existing government bonds worth more.

Despite problems, experts say the worst may be over for mortgage-backed securities.

Until now, “mortgages performed very well relative to Treasuries,” said John Rekenthaler, editor of the Morningstar Mutual Funds newsletter. “I don’t think everyone should necessarily bail out of mortgage securities.”