Mortgage Funds: From Heroes to Bums?

With rates starting to climb, the boom may be over for mortgage funds

Over the past three years, investors with sinking stocks sought shelter in mutual funds that invest in pools of long-term mortgages usually guaranteed by the federal government. They've been well-paid, too, earning nearly as much as they would have on far more volatile U.S. Treasury funds (table).

Now, some portfolio managers of mortgage-backed securities funds are raising a warning flag. With rates on home mortgages climbing up from 40-year lows, the boom days may be over. "Returns will be half of what they've been, and negative returns aren't out of the question" over the next 12 months, says Paul Kaplan, who runs the $26 billion Vanguard Ginnie Mae fund, the largest of its kind.

The risk in mortgage funds became apparent during Wall Street's recent surge. As investors bought stocks, they dumped bonds--especially 10-year Treasuries, the issue against which home lending rates are set. That sent long-term mortgage rates sharply higher, from about 6% to 6.25% during the seven days ended on Oct. 16, according to Bank Rate Monitor. Since the prices of mortgage-backed securities--issued mainly by Government National Mortgage Assn., Fannie Mae (FNM ), and Freddie Mac (FRE )--fall as rates rise, the funds' net asset values sank. The Fidelity Ginnie Mae Fund, for example, lost half a percentage point in value during the week.

This is hardly the kind of roller-coaster volatility investors experience in the stock market. But fund managers fear the problems will only worsen over the next year. Their concerns: the refinancing boom and rising interest rates.

Refinancing is great for borrowers but a problem for mortgage funds. Consumers who refinance pay off their old loans, and the principal is returned to investors--such as mortgage fund managers--who must reinvest in the newer, lower-yielding mortgages that get bundled into securities. The result has been steadily declining yields for these funds. The yield on Kaplan's fund, for example, dropped from 6.4% in February to 5% in mid-October. Total returns remained strong, however, because the lower rates also increased the value of the remaining mortgages.

Now, the funds are stuck with more of the lower-coupon paper. Even if mortgage rates stop rising, fund managers worry their funds would struggle. "As mortgage rates hover around 40-year lows, it gets harder and harder for mortgage funds to have any price appreciation," says Tom Silvia, who runs $8 billion in mortgage funds for Fidelity Investments.

If rates continue to climb, the funds may take an even bigger hit. Kaplan says 7% mortgage rates could result in zero total return for a fund invested in Ginnie Maes. And 8% rates could produce negative results.

Still, mortgage funds can be attractive for income-oriented investors who are willing to ride out the ups and downs in the funds' net asset values. Mortgage funds should continue to pay dividends that exceed those of money-market and short-term U.S. Treasury funds. That's because borrowers pay about 2% over Treasury rates for mortgages. In 1994, their worst year of the past decade, the average total return of mortgage funds was -3.6%, but their average yield was 7.25%.

Not all mortgage managers are bearish. Jeffrey Gundlach, head of fixed-income investing at Trust Company of the West, thinks that "if rates rise, mortgage funds would likely be the top performers" among fixed-income mutual funds, because U.S. Treasury or corporate bond funds fall more quickly in response to rate increases, he says.

Even with the risk of higher rates, some investors may decide it's worthwhile to hold on to mortgage funds. But anyone jumping in anew is paying top-of-the-market prices.

By Geoffrey Smith

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