Mortgage-Backed Funds Might Warrant Another Look

These have been hard times for funds that buy mortgage-backed securities.

Many investors rushed into them to escape low money fund rates in the early ‘90s. But as interest rates fell sharply, homeowners refinanced their high-rate mortgages with lower-rate loans in 1993. That caused returns on mortgage securities to fall sharply.

But now with the market so low, it might be time to take another look at the mutual funds that invest in mortgage-backed securities. They look like a bargain right now.

The larger funds invest in GNMA securities, known as Ginnie Maes, that are backed by residential mortgages. The money from those mortgage payments is passed through to the security holders. The securities are backed by government agencies, so credit risk is minimal.

However, they typically pay slightly higher yields than Treasury securities. They are a good way for conservative investors to eke a bit more income out of their fund holdings.

Many analysts predicted better results for the funds this year, but 1994 hasn’t been so great. Most mortgage funds have limped along, posting poor returns even though interest rates moved sharply higher. The average mortgage fund lost 2.5% over the first eight months of 1994.

But in recent weeks, some portfolio managers of general bond funds have been loading up on Ginnie Maes. Why? As interest rates jumped this year, the refinancing boom ran out of steam. And since the securities had fallen so far, they looked attractive. As more investors notice that fact, their prices are likely to move higher. When that happens, you may want to hold a chunk of your fixed-income portfolio in funds that buy mortgage-backed securities.

One caveat: Avoid mortgage funds that have stuffed their portfolios with exotic derivatives. As interest rates have risen, funds that used derivatives as a hedge were left with huge losses. Piper Jaffray’s Institutional Government Income Portfolio and PaineWebber’s Short-Term U.S. Government Income fund suffered significant and well-publicized losses, in part due to derivatives and other exotic instruments.

Among funds to consider is Vanguard Fixed Income GNMA, which carries no initial sales charge and has annual expenses of only 0.28%.

Fund manager Paul Kaplan took the reins in March when former manager Paul Sullivan retired. But Kaplan had worked at the fund under Sullivan since the fund’s inception in 1980. Together, the two forged an admirable record, beating the typical bond fund’s performance by a solid margin while subjecting investors to below-average risk.

Benham GNMA Income has a history of delivering solid returns at below-average risk. The fund was managed by Jeff Tyler and Randy Merk until December. Since then, Tyler has managed it alone and has made some changes to adapt to shifts in the mortgage marketplace.

In the past, Tyler and Merk devoted much of their time to trying to predict which mortgages were likely to be prepaid as rates fell; thus, they could avoid those securities.

Now, however, prepayments have become more difficult to predict.

At Dreyfus GNMA, manager Garritt Kono has delivered consistently solid returns by sticking with plain-vanilla GNMAs. He occasionally shifts some assets to cash when he thinks GNMAs are expensive or risky; however, he has recently been loading up on mortgage-backed securities, looking for gains as their prices recover.