Mortgage-Backed Securities Make Comeback

Mutual funds that invest in mortgage-backed securities are enjoying a fine rebound this year after a dismal 1994, shoring up confidence in these popular, if complex, investments.

Mortgage fund shareholders who held on through last year’s tough climate earned a 5.7% average return over the first four months of 1995, nearly a point better than taxable bond funds generally, reports Morningstar Inc. of Chicago.

As long as interest rates stay under control and the volume of mortgage refinancings remains low, the investments could continue to perform well.

“Investors are looking at 7% yields on the typical mortgage-backed security, plus perhaps 1 or 2% in price appreciation if interest rates drop,” says David Glen, portfolio manager of the AARP GNMA & U.S. Treasury Fund in Boston.

But unsophisticated investors should exercise caution around mortgage funds, as the underlying securities are more complicated than mainstream bonds. Here are some key characteristics of these funds of which you should be aware:

* Mortgage-backed securities aren’t bonds per se but rather certificates backed by pools of residential loans. As homeowners make mortgage payments each month, money passes through to investors.

* The securities help homeowners by providing liquidity to the real estate market. As banks sell residential loans to investors, they receive cash that can be used for new lending.

* When interest rates drop sharply and homeowners refinance en masse, cash comes flooding back to investors who own mortgage-backed securities. This situation, which also afflicts mortgage funds, becomes a problem when the cash must be put back to work at low yields.

Mortgage securities tend to pay yields roughly 0.5% to 1% more than Treasury bonds, to which they’re typically compared.

* Yet mortgage securities are very safe from a default standpoint. The most secure variety are known as GNMAs, or “Ginnie Maes,” after the Government National Mortgage Assn., a federal agency that packages the loans into securities for sale to investors. Washington guarantees interest and principal payments on Ginnie Maes.

A continuation of the recent trend of flat to slightly lower interest rates would bode well for mortgage funds. A stable-rate environment doesn’t encourage homeowners to refinance. Widespread refinancings have the effect of taking higher-yielding mortgage securities out of the hands of investors and replacing them with lower-yielding ones.

“Today there’s little new supply coming to market, and there’s no sign of a resurgence,” says Glen, who also manages the Scudder GNMA Fund.

At the same time, a stable-rate environment allows mortgage portfolios to perform better than mutual funds that invest more or less exclusively in Treasury bonds, due to the higher underlying yields.

Conversely, Treasuries don’t face the same refinancing problems as Ginnie Maes and thus make a better choice to lock in capital gains during periods of falling rates, says Peter Van Dyke, manager of the T. Rowe Price GNMA Fund in Baltimore.

Also, the derivative scare of 1994, which was centered in mortgage funds, may have taught some lessons to portfolio managers while alerting shareholders to the potential dangers.

Four mortgage funds lost roughly 25% or more last year from derivative speculations, topped by a 28% plunge by the Piper Jaffray Institutional Government Income Fund, headquartered in Minneapolis.

“I think funds in general are scaling back their derivative use,” says Van Dyke.

One interesting wrinkle that could affect mortgage funds this year involves a Republican-led effort to reform the Federal Housing Administration, either making it a privatized company or a streamlined federal agency.

The FHA provides mortgage insurance for residential loans, but critics say the government’s effort here is expensive and competes against coverage provided by private insurers.

Plus, the FHA’s policy of insuring up to 100% of a loan’s value encourages homeowners to default when times get tough, says Suzanne Hutchinson, executive vice president of the Mortgage Insurance Cos. of America, a Washington-based trade organization for private insurers.

FHA supporters, in turn, say many marginal home buyers would have trouble qualifying for private mortgage insurance, especially during difficult economic periods.

What observers on both sides of the FHA issue seem to agree on is that there’s a good chance Congress will move to reform the agency sometime soon. The scope of reform isn’t known, although some believe a likely restructuring effort would involve streamlining the agency’s programs rather than, say, spinning it off as a privatized company.

Considering that 70% of the mortgages in Ginnie Mae securities are FHA-insured loans, reform could affect the investment market. But unless government guarantees on the $350 billion worth of existing Ginnie Maes are somehow jeopardized--deemed by several fund managers to be unlikely--the impact will be gradual.

“From what I can perceive, there has been no concern in the market about the possible impact on Ginnie Maes,” says Ken Willmann, manager of the USAA Investment GNMA Fund in San Antonio.

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The Montgomery MicroCap Fund, a small-stock portfolio run by hot-handed Roger Honour, plans to open its doors to new investments June 1.

The no-load fund, headquartered in San Francisco, stopped taking cash from new shareholders on Jan. 28, just 29 days after it was launched, in order to digest an influx of cash. The fund currently weighs in with about $110 million in assets, but will stay open this time around until assets hit $200 million or so.

Montgomery MicroCap, at (800) 572-3863, returned 6.8% from Jan. 1 through April 30. Honour turned heads by guiding another fund, Montgomery Growth, to a gain of nearly 21% in 1994.

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Financial services stocks, including mutual fund companies, are among the cheapest picks in today’s expensive market, says Donald Yacktman, portfolio manager of the Yacktman Fund in Chicago.

Among corporations that run fund families, his selections include Franklin Resources of San Mateo, Calif., Torchmark Corp. of Birmingham, Ala., and Boston-based United Asset Management.

All three stocks trade at double- digit discounts to their record-high share prices.

Yet “money management is an excellent business,” says Yacktman, who searches for sound companies selling at steep markdowns from past price levels.

Yacktman, named Portfolio Manager of the Year by Morningstar Inc. of Chicago in 1991, suffered through a sharply sub-par 1993 but has rebounded since then.