Refinancing Surge Could Hit Some Bonds

Fixed-income investors who flocked to mortgage securities in search of higher yields may see their returns suffer if the recent dip in interest rates leads to a new wave of mortgage refinancings, as many analysts expect.

Mutual funds that invest in government-backed mortgage bonds have posted a total return--interest plus price appreciation--of 6.1% this year. That’s “still solid ... although their performance has slipped a bit in recent months,” said Morningstar Inc. analyst Scott Berry.

But when interest rates tumbled last week to lows not seen since the early 1960s, lenders and investors were bracing for a new wave of mortgage refinancing that was expected to push total mortgage volume to the level of last year’s record of $2.2 trillion, or even higher.

Even though yields on Treasury securities had rebounded a bit by late Friday, a key index of home mortgage rates ended the week at 6.22%.

It’s uncertain how long rates will remain at such levels. Interest rates have been highly volatile since last fall, and many analysts were saying last week that yields had fallen so low that investors would be induced to pull money out of the bond market and invest it in stocks instead. That could fuel further rises in Treasury yields.

But if mortgage rates remain depressed long enough for home buyers to refinance--some for the second or third time in a year--mutual funds that hold mortgage bonds probably would see their returns slip.

Government National Mortgage Assn. securities--known as Ginnie Maes--that carry 7% yields are being refinanced at an annual rate of at least 40%, bond fund managers said. That means older, high-yielding securities are replaced with newer, lower-yielding issues, pushing the yields on mortgage-bond funds to 5% or less.

Even that’s not such a bad yield these days, said Bill Powers, a portfolio manager and managing director at Pacific Investment Management Co. in Newport Beach. A fund with that much turnover in its portfolio probably is best compared to a two-year Treasury bill, Powers said, and two-year Treasuries are paying about 2.2%.

But it’s still far below what mortgage investors have become accustomed to in the mutual funds that hold Ginnie Maes. These securities, whose principal is guaranteed by the U.S. government, have become tremendously popular because they “have offered a little more yield than Treasuries and less volatility,” Berry said. That combination is so attractive that “a lot of bond investors use mortgage bonds as their core government holding.”

Because the principal on these securities is secure and the yields are higher than those on 10-year Treasury bonds, investors seeking safety and yields sent a net inflow of $8 billion into Ginnie Mae funds in 2001 and an additional $4.6 billion during the first half of this year, said data firm Lipper Inc. Complete data for July aren’t available, but the inflows remained quite strong, Lipper research analyst Martin Vostry said last week.

But these investors increasingly have had to settle for less, as homeowners replace higher-interest mortgages with lower-rate home loans. In July 2000, the yield on the Vanguard GNMA Fund, the largest holder of mortgage-backed securities, was 6.9%; it has slipped to 5.2%, Morningstar said. Fidelity’s Ginnie Mae fund has seen its yield decline from 6.6% to 4.8% in the same period.

Another risk is that when interest rates eventually go back up, the value of the mortgage securities paying lower interest will decline--and they’ll stay on the books because they won’t be refinanced. The only time since 1981 that the total return on the Vanguard GNMA Fund posted a negative annual return was in 1994, when the Federal Reserve raised interest rates six times, Berry said.

Such a reversal seems unlikely these days, given the worrisome weakness in the U.S. economy and the fragile nature of the equity markets, which would be further spooked by a Fed-inspired spike in interest rates. But many mortgage bond investors aren’t fully aware of how badly they could be whipsawed if rates rise, said Jeffrey E. Gundlach, a senior fixed-income strategist at the TCW mutual fund group.

“I still think mortgage securities represent a good place to be,” he said. “But sadly, the effect of lower rates is to make it a less attractive place than it was.”