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CEFs Banking on a Housing Recovery

Jeremy Glaser
Cara Esser, CFA

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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Glaser: What kinds of funds are making these mortgage-backed security bets?

Esser: So, there are a handful of funds that are mortgage-related funds. They actually invest almost all of their assets in mortgage-backed securities and asset-backed securities. Obviously investors would expect it from there. But there are about 30 funds in the taxable-bond universe, which is about a fifth of the total funds in the universe, that invest at least 10% of their assets in mortgage-backed securities.

So, you might expect this from a multistrategy fund that has the freedom to go across different sectors within the fixed-income space, but we also see these investments in investment-grade funds, high-yield bond funds, short-duration funds, and globally invested funds.

Glaser: What kind of allocations are we talking about? You mentioned that about 30% of the BarCap is in mortgage-backed securities. Are managers taking bets way beyond that?

Esser: It varies widely. A lot of them have let's say between 10% and 40%, which is a relatively reasonable amount invested in this kind of a security, but some of these funds have invested all of their assets in these securities.

So, a good example would be PIMCO Dynamic Income, ticker PDI, and also DoubleLine Opportunistic Credit, ticker DBL. These were both launched last year as go-anywhere fixed-income strategy funds, and they both currently have nearly all of their assets invested in not only mortgage-backed securities but specifically  in nonagency residential mortgage-backed securities. So they're taking a big bet on this housing market recovery.

Glaser: Before diving into some of these CEFs, it makes sense to think about how much exposure you want to mortgage-backed securities and then see how much you're actually getting there?

Esser: Yes, you definitely have to dig a little bit deeper because you want to make sure that you know where your fund is getting its exposure from.

Glaser: Cara, I really appreciate you taking the time today.

Esser: Thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser.