Mortgage bonds reward yield-sensitive investors

WASHINGTON Tue Dec 31, 2013 7:03am EST

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WASHINGTON (REUTERS) - Investors searching for higher yields from rock-solid investments were put on hold again last week by the Federal Reserve, which pledged to keep interest rates low even as it scales back its extraordinary monetary easing.

While the Fed is not expected to raise its benchmark overnight interest rate for nearly two years, savers may be able to build reliable income streams by investing in mortgage-backed securities issued by Fannie Mae and Freddie Mac, the taxpayer-owned mortgage finance companies. Their bonds are considered to be safe and they beat the rates paid on U.S. Treasury securities and bank account deposits, say analysts.

Ironically, these are the very same types of securities that were blamed for being part of the problems that precipitated the 2008-2009 financial crisis. But with quasi-governmental status and federal backing, none of the bonds went bad despite problems in the housing market and the economy. Both of these government-sponsored enterprises still issue mortgage-backed securities, with current rates above U.S. Treasuries, and they have not missed a payment.

With the 5-year U.S. Treasury note yielding about 1.7 percent, an investor can expect a mortgage-backed bond from Freddie Mac or Fannie Mae with the same maturity to yield about 1 percentage point to 1.5 percentage point more, Franco Castagliuolo, a portfolio manager at Fidelity Investments, said.

Federal regulators placed both mortgage giants under conservatorship in 2008 and supplied massive government assistance; analysts who follow Fannie and Freddie say these securities carry an implicit government guarantee and are seen as safe. In the wake of the mortgage and housing crisis, these quasi-governmental loan packagers have been handling a larger share of the mortgage market.

About two-thirds of all mortgages being issued now are being packaged into securities by Freddie Mac and Fannie Mae.

RISK FREE, SOMEWHAT Investors who buy mortgage-backed securities from Fannie Mae and Freddie Mac and hold those bonds until they mature will get their full investment back; there is no "principal risk."

Still, there are other concerns. One risk is holding securities with low interest rates in a rising interest-rate environment, Castagliuolo said. That could leave the money of bondholders stuck in low-yielding instruments while new issues pay better rates.

Owners of mortgage backed bonds also face refinance risk, though that tends to be more of an issue when rates are falling. In those periods, homeowners refinance and pay their loans off early, leaving the bondholder stuck with money they have to reinvest at lower rates.

Another unique characteristic of mortgage-backed securities is the way they are repaid. Every month, borrowers pay back some principal as well as some interest, and that is the way bond investors receive their money. Careful investors know they will need to reinvest the principal portion of the payments they receive if they want their investments to last. They also need to keep careful records of investments and withdrawals so that they don't overpay their income taxes by paying gains taxes on principal they receive.

Most investors buy mortgage-backed securities via mutual funds or exchange traded funds that specialize in them. The upside of that is diversification and low cost management (if you're choosing a low-cost fund.) But most funds don't have maturity dates, so fund investors have to do without having that one date certain when they know they can get their principal back in full. Fund investors should also make sure that their funds limit themselves to high grade quasi-government debt, and don't fill their portfolios with higher-risk corporate bonds.

CHANGE IS COMING, BUT IT IS UNCLEAR

Washington has spent years debating what to do with Fannie Mae and Freddie Mac in the future, and quick change is unlikely.

Even if Fannie and Freddie are privatized, older bonds would be safe, suggests David Reiss, a law professor of real estate finance at Brooklyn Law School.

"The government would not change the rules of the game for securities purchased with the guarantee. Pre-privatization (securities) would retain the guarantees, and future securities would have a different type of guarantee," he said.

For now, he says, investors are relatively safe: "Effectively the only risk is the interest rate risk."

(Follow us @ReutersMoney or here Editing by Linda Stern and Andrew Hay)

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Comments (1)
gunste wrote:
Let’s face it, the most likely reason the Fed is keeping interest rates low is the minimize the cost of financing the US deficits.
The fact that everyone who has his finances in good order, saves for retirement or, in retirement lives of the income of his savings, they are all in poor shape, courtesy of the negative income from savings.
The Fed’s excuse of the need to prop up banks is doubtful, since the banks are not doing what is expected of them – lend to small business. Much better to speculate and charge exorbitant fee for normal services.
The primary benefactors of the Fed’s action is the stock market, since investors with money and the funds have been bidding up the market into a new bubble, searching for yield and profit – supported only by the cash stocks that corporate America is accumulating and using to buy back its stocks.
Greenspan’s policies were instrumental in building the housing bubble in 2000-2008. Will 2014 be remembered as the Bernake bubble in the stock market?

Dec 31, 2013 1:44pm EST  --  Report as abuse
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