Dan Culloton: Another big area of emphasis for the fund is mortgage securities, particularly those backed by government-sponsored agencies, but a good portion of those mortgage securities are backed by or tied to mortgages taken out by people who have impaired credit or fallen behind on their mortgages. How does that square with your overall efforts to create a good risk-reward profile for the fund?
Tom Dugan: All the fund's--or nearly all, there may be one very small position--mortgage securities are guaranteed by either Fannie Mae or Freddie Mac, and those entities are now under federal conservatorship, and so they have a significant line of credit with the U.S. Treasury that backs the guarantee that backs their obligations. So the credit risk associated with those securities, we think, is pretty good.
We invest in mortgage securities primarily in the intermediate part of the yield curve, typically securities between two and five years, you are going to realize most of the cash flows from them. And the primary risk in the absence of a significant credit risk associated with the issuer is prepayment risk, and a significant portion, as you've mentioned, of the mortgage securities that are in the Income fund were loans that these borrowers took out in the 2007-2008 timeframe.
Since then, home prices have gone down substantially and many of the borrowers underlying those mortgage-backed securities find themselves in a position where basically their home may be worth less than their loan. While that's obviously an unfortunate situation for that individual to be in, the ramifications of that from an investor in a mortgage-backed securities portfolio where the principal is guaranteed by Fannie Mae and Freddie Mac is that it's very hard for that borrower to take advantage of refinancing opportunities.
And this is a classic example of using our in-depth research process to try to isolate factors that are going to influence returns going forward. In the case of these particular mortgage-backed securities, it's these types of borrowers, their inability to refinance in today's low mortgage rates, makes those securities very attractive because the prepayment rates have been quite slow, and the returns have been very attractive.
Culloton: So you are not trading prepayment risk for default risk?
Dugan: No, that's the trade-off in mortgage securities that are not guaranteed by the federal agencies. In this case the credit risk is effectively assumed by Fannie Mae and Freddie Mac, and we face the prepayment risk. Because of the particular credit dynamics of the borrowers that underlie the Fannie Mae and Freddie Mac pools we're buying, that has influenced the prepayment risk and, in our view, has lowered it somewhat, and has increased the attractiveness of those securities.