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Morningstar
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Don't scrap your mortgage fund
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Yes, mortgage funds have seen yields drop with falling interest rates. But they have strengths that other bond funds dont have that could make them good buys for the future.
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By Scott Berry
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The housing market is red hot, mortgage rates have sunk to record lows, and refinancing activity is fueling the economy. Unfortunately, what's been a boon for homeowners has been a bust for mortgage-focused bond funds.
Mortgage funds fared quite well when interest rates dropped in 2000, 2001, and 2002. But falling interest rates have had a negative effect on the group over the last six to nine months. That may seem counterintuitive; falling interest rates typically bode well for bond funds. But recently, mortgage funds have followed their own path, as re-financings have weighed on their returns.
The biography of a mortgage loan
Tracing the life of a typical mortgage loan may help illustrate the sensitivities of mortgage funds. Let's assume a homeowner bought a house in 1997 and financed the purchase with a 7%, 30-year, fixed-rate mortgage. Now lets say that mortgage gets purchased by Freddie Mac (FRE, news, msgs), which then sells it to a mutual fund. (In reality, the loan would get pooled with others, securitized, and guaranteed by Freddie Mac, which is a U.S.-government-sponsored agency, but let's keep it simple).
The fund earns principal and interest on the mortgage for a few years. Then, in 2002, mortgage rates dip to 6.5%. That 7% mortgage has likely increased in value, as it is now paying a higher yield than new mortgages. And at 6.5%, mortgage rates aren't likely to prompt the homeowner to refinance due to the costs involved.
Skip ahead a year to June 2003. Mortgage rates are now at 5.0%, and the homeowner has more than enough incentive to refinance. The homeowner pays off his old mortgage, so the fund loses its 7% holding, which was trading at a premium, and is forced to reinvest the proceeds (the remaining principal value) at 5%.
Most mortgage funds have posted positive total returns for the year to date through June 18, 2003, but they have struggled relative to diversified government-bond offerings, which invest in more rate-sensitive Treasury and agency bonds, as well as the same securities that mortgage funds do--namely, mortgages backed by Freddie Mac, Fannie Mae (FNM, news, msgs), or Ginnie Mae. A number of them have even seen their net asset values slip a bit. Scudder U.S. Government Securities (KUSAX, news, msgs) has dropped $0.06 since the first of the year, for example, while Franklin U.S. Government Securities (FKUSX, news, msgs) has dipped $0.05.
Mortgage fund trailing returns | | | YTD total return (%) | 1-year total return (%) | 3-year avg. return (%) | 5-year avg, return (%) | | | Fidelity Ginnie Mae (FGMNX) | 1.13 | 5.54 | 7.87 | 6.43 | | | Franklin U.S. Government Sec. (FKUSX) | 1 | 5.46 | 7.97 | 6.37 | | | Putnam U.S. Government Income (PGSIX) | 0.46 | 4.16 | 7.15 | 5.77 | | | T. Rowe Price GNMA (PRGMX) | 1.76 | 6.3 | 8.47 | 6.54 | |
Vanguard GNMA (VFIIX) | 1.98 | 7.06 | 8.75 | 7.04 | | | Intermediate-Term Gov't category average | 2.53 | 7.6 | 8.62 | 6.48 | |
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Data as of 06-20-03.
Source: Morningstar
Mortgage funds have strong merits
That doesn't mean it's time to bail out, though. Mortgage funds have historically offered more protection against modestly rising interest rates than funds focused on Treasury and agency bonds. And with rates at historically low levels, the next big move could be higher.
Also, many mortgage funds continue to offer more yield than other government bond types. The T. Rowe Price GNMA (PRGMX) and Vanguard GNMA (VFIIX) funds recently yielded 4.2% and 4.6% respectively. In contrast, Vanguard Intermediate-term U.S. Treasury Fund (VFITX) yielded just 2.3%. Should rates simply level out, that added yield should give mortgage funds a definite advantage.
This has been a rough stretch for mortgage bond funds, and they certainly face risks going forward. It's even possible mortgages could suffer more than Treasurys if interest rates rise dramatically. However, they have proved their worth over the long-term and can still serve as a building block for a diversified portfolio.
(c) Copyright 2003. Morningstar, Inc. All rights reserved.
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