Falling interest rates have sent home refinancings to their fastest pace
since February, 1996. And that could spell bad news if you're an investor in mortgage-backed bond or mutual funds.
Most home mortgages are bundled together and sold to investors looking for steady income. But when refinancings soar, many mortgages get paid off early. That means you or your mortgage-backed fund could be getting your principal back a lot sooner than you expected--at a time when options to reinvest in higher-yielding mortgage-backeds are scarce. Indeed, that's what happened in 1993, when bond yields plummeted, refis soared, and investors in mortgage-backed securities got left behind.
When the bond market is stable, only 6% to 7% of outstanding mortgages are paid off early. But prepayments now run at a 15% rate. Dan Dektar, bond fund manager for Smith Breeden Associates, thinks they could soon return to their 1993 rate of 40%. If long-term Treasury bond yields fall only 50 basis points from today's 6.1%, "we will see some very fast prepayment speeds," he says. "We're looking down a gun barrel."
Whether you should get out of mortgaged-backed funds now depends on your objective. For the year ended Oct. 31, mortgage funds outperformed intermediate-term Treasury funds, returning 8.1% vs. 6.8%. But they tend to lag Treasuries during periods of raging refinancings. That's what happened in October, when mortgage funds returned 1.05%, vs. 1.35% for intermediate-term Treasury funds. So if you depend on income from mortgage investments to meet day-to-day needs, now may be a good time to exit.
And if you're looking for bargains, now probably isn't a good time to buy mortgage-backed funds, either. "At this point in the interest-rate cycle, it's better to buy a more diversified bond fund," recommends Bill Powers, a managing director at Pacific Investment Management Co. PIMCO has reduced its mortgage-backed investments from $50 billion to $35 billion.
But if mortgages form part of a long-term diversification plan, and you don't need the extra yield, you may want to stay the course. Many managers have already moved into older mortgages or lower-coupon bonds that are less sensitive to prepayment risk. Paul D. Kaplan, manager of the $8.5 billion Vanguard GNMA Fund, has kept his 8% Fannie Mae mortgage-backeds that date to 1993. These are made up of mortgages that are "seasoned," which means they were taken out by homeowners who had a chance to refinance in 1993 and didn't. The chances of them refinancing now are slim, despite falling interest rates.
DEFENSIVE ACTION. Some managers are trading out of higher-coupon mortgages that are seeing lots of prepayment activity and buying lower-yielding securities. Peter Van Dyke, manager of T. Rowe Price GNMA funds, has shifted about 90% of the $2.3 billion he manages into 5.75% and 6% mortgage-backeds. If rates head higher, the value of his mortgage-backed debt will fall. Dektar defends his assets by buying sections of collaterized mortgage obligations known as plan amortization class bonds. They have some built-in protection against prepayment and provide a more stable cash flow than the underlying mortgages.
Although managers have plenty of prepayment scenarios, what's important is whether they invest accordingly, says Morningstar's senior fixed-income analyst, Mark Wright. Earlier in the 1990s, many ignored their models and paid dearly. So you should ask what's going on with your fund and what kind of exposure it has to different markets. If you haven't, now is a good time to do it.