August 1, 2012 / 3:40 PM / 7 years ago

Stern Advice: GNMA funds have a following despite low rates

WASHINGTON, Aug 1 (Reuters) - Lately mortgage interest rates have been hitting one record low after another. At the same time, we’re seeing increases in mortgage defaults, foreclosures and short sales in which lenders get less than 100 cents to the dollar for the loans they’ve let. So why would anyone want to be a mortgage lender right now?

That would be a good question to ask investors who have thrown $6.9 billion into Government National Mortgage Association (GNMA)-backed mutual funds in the year ending June 30, according to figures from Lipper, a Thomson Reuters company.

They have their reasons. GNMA-backed mortgages are backed by the government, so they are relatively risk-free. Even at record lows, they yield more than Treasuries do. And Federal Reserve policymakers have hinted that they might be willing to buy big bunches of these mortgage-backed bonds if they have to do another round of quantitative easing to stimulate the economy.

Theoretically, then, an investor could buy some shares of a mortgage-backed bond fund, reap the higher (than Treasury) yields and then sell at a profit to the Fed. Past performance — while not indicative of future results, as the saying goes — indicates that people who stuck with these funds have done OK. Through June 30, GNMA funds have averaged 6.56 percent total returns for the last five years and 5.97 percent for last three years, according to Lipper. That’s middling - on a total return basis, they’ve outperformed riskier high-yield bond funds but underperformed general Treasury funds.

The Fidelity GNMA Fund, a Morningstar favorite, is yielding 2.81 percent now and has returned an average of 7.41 percent a year for the last five years through July 30.

So, as with any other investment, there are pros and cons. Here are a few points to keep in mind before you start buying mortgages.

— It’s different. When you hold mortgages, you’re really on the opposite end of homeowners. So when rates fall, instead of getting rich on the higher-rate bonds you hold, you lose them quickly when homeowners refinance to lower rates. Going up, the reverse is true: Mortgages only get paid when people sell their homes, so you have less money free to reinvest at higher rates. “This would make the bond go down in value more than the damage caused by rising interest rates,” says Don Martin, a Los Alamos, California, wealth manager.

— It’s moderate. “Yields are not terribly competitive with the kind of income you would find in corporate bonds” says Jeff Tjornehoj, an analyst with Lipper. “But they are steady.” Furthermore, he says fund managers are picking up returns by buying new pools of mortgages. “A lot of houses are underwater but still performing” — meaning that homeowners are still making their monthly payments. “But that makes refinancing impossible.” These mortgages tend to have interest rates in the 4.5 percent to 5 percent range — yields which look pretty good in today’s market.

— Investors should stay guarded. “These are good investments, but one should never let down their guard about the risk of inflation damaging bonds,” says Martin. “The bond vigilantes have defected to become bond lovers, and they can change back to being vigilantes if they see inflation returning.”

— The Fed could come back. Back in 2009 and early 2010, the Federal Reserve bought some $1.25 trillion in mortgage-backed securities. But as they came due, the Fed began replacing them with Treasuries. It later went back to replacing mortgage-backed securities with like investments when they came due, but — as of last week — held about $945 billion in mortgage-backed bonds, some $80 billion less than their peak. Federal Reserve policymakers have said many times that they stand ready to pump more cash into the economy if they perceive that need, and a few have suggested that new mortgage-backed bonds could be on their shopping list. Buyers who got in before the Fed might look at that next round of quantitative easing as an opportunity to get out of mortgage-backed bonds and into something a little more growth-friendly.

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