Mortgage-backed bonds deserve a good home

5/19/2008


Spooked by troubled credit markets, a dismal housing backdrop, and volatile equity markets, investors seeking safety have poured money into Treasury bonds. Meanwhile, the Federal Reserve has slashed short-term interest rates. The result: skimpy yields on conservative investments, particularly Treasurys. The 10-year Treasury bond pays only 3.9%, versus a 20-year average of 6.0%.

While a flight to safety has pushed Treasury yields near 30-year lows, the spread between yields on mortgage-backed securities and Treasurys has widened. Mortgage-backed securities are made up of pools of loans that are typically the first mortgages on residential properties. In mid-March, the spread based on Fannie Mae mortgage-backed securities reached its widest level in more than 20 years at roughly 2.4%. While the spread has since narrowed to about 1.5%, today’s high relative yields suggest investors should consider holding some of their fixed-income portfolios in mortgage-backed securities.

Based on the Lehman Brothers U.S. Aggregate Bond Index, government-backed mortgage securities represent roughly 37% of the investment-grade bond market, compared to 35% for Treasury bonds. The Lehman Brothers U.S. MBS Index, a broad gauge of the mortgage-backed market, has notched a positive return for 13 consecutive years. Up 7.1% over the past 12 months, the index delivered a 15-year annualized return of 6.3% through March 31, matching the performance of the benchmark index.

Investors looking to exploit the yield spread and bolster diversification should consider an exchange-traded fund (ETF) or mutual fund. The iShares Lehman MBS Bond Fund ($102; ASE: MBB) holds mortgage-backed securities issued by a government agency such as the Government National Mortgage Association (GNMA or Ginnie Mae) or a government-sponsored entity such as Federal National Mortgage Association (Fannie Mae) or Freddie Mac. Principal and interest payments are generally guaranteed by the agencies, which can access lines of credit from the U.S. Treasury. The fund boasts an average credit rating of AAA from Standard & Poor’s. The ETF yields 4.8% and has an expense ratio of just 0.35%.

Conservative investors should consider Forecasts recommendation Vanguard GNMA ($10; VFIIX). The fund invests at least 80% of its assets in Ginnie Maes, which are backed by the full faith and credit of the U.S. government, potentially sidestepping some negative headlines. The fund, yielding 4.8%, has an average credit quality of AAA and charges only 0.21% annually. The fund, which has handily outpaced the peer-group average over the last one-, three-, five-, and 10-year periods, has had one down year since 1990.


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