Collateralized mortgage obligations have gotten a lot of bad press in the past year. Heavily marketed to yield-seekers because they pay more than comparable Treasury securities and come with a government guarantee of principal and interest, CMOs are nevertheless among the trickiest investments around. Their biggest risk has risen as interest rates have fallen: When homeowners refinance their mortgages, CMO holders get their principal back early and are forced to reinvest at lower rates. That so-called prepayment risk is as manageable as a Great Dane puppy.
AN ALTERNATIVE. But some fixed-income money managers think now may be a good time for investors to reconsider CMOs as a higher-yield alternative to certificates of deposit and Treasuries. First of all, prepayments are fewer than they were a year ago. That is because mortgage rates, now at their lowest level in 20 years, have been down long enough that the people who want to refinance already have done so. In some cases, falling property values or incomes have trapped mortgage holders in their current loans because they couldn't qualify for new ones.
Also, selective buying of older or shorter-term CMOs can reduce the prepayment risk further. "You can pick your way through the market and find attractive securities," says Bradley Tank, portfolio manager of the $80 million Strong Government Bond Fund. Tank says his fund is normally one-third invested in CMOs and other mortgage-backed securities; now he has ramped that up to one-half.
He cites 15-year mortgage passthroughs--government-agency mortgage pools repackaged by an investment company--issued in 1985. Such bonds have coupons of 8% to 9.5% and are trading at a premium of 104 to 106. For one thing, says Tank, they have already gone through three major refinancing cycles. Also, "you're seven years into the amortization schedule and fairly heavily into principal. So prepayment will affect the bond less."
Similarly, the $441 million Eaton Vance Government Obligations fund buys so-called seasoned mortgages: loans taken out in the 1960s or '70s at rates at or below current levels. The rationale is that people already paying single-digit mortgage rates don't have the incentive to refinance now.
MATURITY. Can individual CMO investors emulate these strategies? "I would argue strongly that prepayments of 10%-and-up coupons will slow down," says Robert Andres of investment firm Martindale, Andres & Co. Gerald Guild, fixed-income manager at Advest, isn't quite so sanguine. "On the other hand," Guild says, "the wonderful thing about bonds is that my mistakes mature at face value." But remember that if refinancings do pick up again, CMOs may mature long before you expect them to.