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By Jeremy Glaser and Cara Esser, CFA | 02-05-2013 02:00 PM

CEFs Banking on a Housing Recovery

Anticipating a housing recovery, many CEFs are taking stakes in mortgage-backed securities, but make sure you're comfortable with your fund's exposure.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Cara Esser; she's a closed-end fund analyst at Morningstar. We're going to look at mortgage-backed securities and the role that they play in CEFs.

Cara, thanks for talking with me today.

Cara Esser: Thanks for having me.

Glaser: So let's start with kind of a high-level overview of what are mortgage-backed securities, and why should investors care about them?

Esser: Mortgage-backed securities are used in a lot of fixed-income portfolios, and essentially you are getting the cash flows from the principal and interest of certain mortgages. So it's either principal or interest or some combination of the two. So, there are a lot of different types of mortgage-backed securities.

Some of the most common are commercial, residential, and collateralized. They all mean different things. They all get their cash flows from different types of mortgages. They can be agency-backed, which means that they have the guarantee of like Fannie Mae, Freddie Mac, and Ginnie Mae. They could be nonagency, which means they don't have that government guarantee. They also can vary in quality. So you have prime, Alt-A, and subprime; prime obviously being of the highest quality and subprime of the lowest quality.

Glaser: Certainly during the financial crisis, we heard a lot about subprime; we heard of a lot of mortgage-backed securities that didn't produce that income that was expected. So, should investors be concerned if there are mortgage-backed securities in their funds now, or has the market really changed a lot during the last couple of years?

Esser: I think investors don't need to be concerned about minimal exposure to mortgage-backed securities. The Barclays Aggregate Bond Index actually has about 30% exposure to mortgage-backed securities. So, you would expect that any kind of broadly invested fixed-income portfolio will have at least some exposure to these securities. You really need to be more worried about the funds that are overly invested in these securities that are really taking a bet on a specific area of the mortgage-backed security, not just mortgage-backed securities in general.

So, for example, a lot of the closed-end funds now we see are taking a bet on nonagency residential mortgage-backed securities. They're getting the cash flows from homeowners. So, if the housing market goes under again, these obviously have a difficult time performing, but a lot of these managers are taking bets on a recovering housing market.

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