Mortgage Fears Yield Opportunity for Bond Funds

These days, the mere mention of the term "mortgage-backed securities" could make investors queasy. If you own a core bond fund, chances are that it invests in mortgage bonds (all but 10 of the more than 300 funds in Morningstar's intermediate-term bond category own mortgage bonds of some type). Even under normal circumstances, understanding the risks present in a fund's mortgage portfolio can seem like a daunting task. Information on the quality and characteristics of the many individual loans that support a mortgage bond can be difficult to come by, and the structure of the bond itself can appear impenetrable.

The parade of stomach-wrenching headlines doesn't help, either. Every week brings news of another high-profile casualty of the subprime-mortgage meltdown: Home lender Thornburg Mortgage, private-equity firm Carlyle Group, and investment bank Bear Stearns are the latest in a string of debacles. Fears about what risks are still concealed in investment vehicles and on the balance sheets of financial institutions continue to dominate the current environment, and that's pushed prices down on riskier bonds--including murky issues supported by payments on failing subprime loans--as well as prices on mortgages that carry very little credit risk.

Although the environment may look bleak, we don't think investors should run screaming from mortgage bonds. In fact, we're hearing from more and more of our favorite bond-fund managers that recent volatility has created tremendous opportunity in some areas of the mortgage bond market. We wouldn't suggest that investors load up on individual mortgage bonds, but they also shouldn't avoid the funds that own them. Here's why ...

Agency Mortgage Bonds: Yep, Still Safe
When Thornburg and Carlyle ran into trouble with their creditors in the first week of March, the gap between yields on Treasury bonds and mortgage bonds issued by government agencies Fannie Mae and Freddie Mac widened to their highest level since 1986. According to many observers, this was only the latest example of the market responding to concerns that a flood of agency mortgage bonds would be dumped on the market at a time when banks and other financial firms have limited capacity, if any, to buy them. As an added sign that the market isn't appropriately valuing the fundamentals of this sector, the additional yield that investors require for holding Ginnie Mae mortgage bonds, which are directly backed by the U.S. government, has also reached historically high levels.

But Bill Gross and company at PIMCO (Morningstar's 2007 Fixed-Income Manager of the Year) are singing the praises of agency mortgage bonds. Scott Simon, who leads PIMCO's mortgage efforts, points out that mortgage bonds issued by Fannie Mae and Freddie Mac are supported by the higher-quality U.S. home borrowers rather than the beleaguered subprime borrower. What's more, the bonds are bolstered by several layers of protection in the event that borrowers default on their loans, according to Simon. The typical Fannie and Freddie mortgage loan amounts to 59% of a home's underlying value, for instance, which means that bondholders have an extra 41% cushion against falling home prices. Fannie and Freddie also guarantee payments on the bonds that they issue, and Simon doesn't see even a severe housing downturn putting that in jeopardy. Lastly, although Fannie and Freddie bonds don't enjoy the same guarantee as their Ginnie Mae cousins, many consider them "too big to fail"--the roughly $4 trillion in agency mortgage bonds outstanding (Ginnie Mae's included) is even larger than the $3 trillion Treasury bond market--and would expect the government to step in under the most dire circumstances. The PIMCO team's conviction in agency mortgages has been palpable: Sizable stakes in Fannie and Freddie bonds are even cropping up in unusual places in the PIMCO lineup, such as  PIMCO High Yield  and  PIMCO Global Bond (Unhedged)  .

But don't take PIMCO's word for it. Manager Bob Rodriguez of  FPA New Income (FPNIX), who's earned a reputation as a fierce protector of shareholder capital, also ranks among the many fund managers sticking with agency mortgage bonds. Lax underwriting standards in the mortgage arena raised red flags for him as early as 2005, and he's positioned the fund defensively ever since, most recently placing a halt on all high-yield bond orders for the fund until the credit crisis subsides. Since New Income held roughly 40% in agency mortgage bonds (and another 29% in agency debentures) as of the latest public portfolio, investors can also take comfort from Rodriguez's confidence in these bonds. After all, in the 25 years since he started managing this fund, it hasn't lost money in a single calendar year.

Stepping Outside of the Agency Comfort Zone
Not all residential mortgage bonds are issued by government agencies, though, and this is an area where the market's risk-aversion has opened up pockets of opportunity. Private mortgage lenders and financial institutions pool together mortgage loans that don't conform to Fannie's and Freddie's standards and issue them as bonds. Because these bonds can differ dramatically from one another in terms of the strength of the underlying loan collateral and structural support, managers have to carefully pick them apart to differentiate between the winners and the dogs.

When it comes to buying mortgage bonds--agency or nonagency--few have operated with as much acumen as Jeffrey Gundlach and crew at  TCW Total Return Bond (TGLMX). When put to the test during the credit crisis, the fund hasn't missed a beat. According to Gundlach, the complexity of mortgage bonds has produced numerous past instances where investors were left lamenting--"I thought I owned this, and now I realize I own that." So not surprisingly, careful bond-by-bond research and rigorous stress-testing are cornerstones of his approach. In his view, current market conditions offer unprecedented value for the most senior bonds backed by Alt-A mortgage loans, which are considered riskier than higher-quality prime loans but not as risky as subprime. Many of these bonds have been trading at prices akin to high-yield corporate bonds, and Gundlach's analysis shows that the bonds can more than withstand an extreme rise in defaults. It may take a while for the market to come around to his point of view, but given Gundlach's experience and impressive track record, we think his latest bargain-hunting bodes well for the fund's long-term prospects.

Treading Carefully in Commercial Real Estate
Bonds backed by loans on commercial properties, or commercial mortgage-back securities, have also struggled mightily in recent months. Prices on these bonds took a hit in the initial stages of the credit crisis, but their woes were amplified in 2008. As a group, CMBS experienced their worst months on record in January and February of this year. Headlines have connected the dots between CMBS and subprime, citing similarities such as increased loan leverage, loosening underwriting standards, and a boom in issuance in recent years as potential warning signs.

Although many agree that the commercial real estate market may see tougher days ahead, fund managers have started to find attractive the current prices on the highest-quality AAA rated CMBS. Scott Amero and crew at BlackRock made these bonds the subject of a recent market commentary in which they point out that, similar to the problems faced by agency mortgages, many hedge funds and trading desks are facing pressure to sell higher-quality CMBS as they reduce debt, forcing the bonds into a market that has no appetite for them. The BlackRock team argues that the AAA CMBS, which carry built-in protection against losses of as much as 30%, offer stronger support than similarly rated subprime-backed bonds. Also, they prefer older loans, which haven't suffered from the poor underwriting quality and leverage prevalent in more recent issues.

Treasuries Aren't Risk-Free
Investors still looking for a safe place to hide may be tempted to turn exclusively to Treasury bonds or funds with heavy stakes in Treasuries. Unlike just about everything else in the bond market these days, Treasuries are still easy to trade, so they give fund managers the flexibility to meet redemptions (when necessary) or pounce on more attractive investment opportunities as they arise. And unlike residential mortgage bonds, which are subject to fluctuations in the rates at which borrowers refinance their mortgages, Treasuries don't require any guesswork about when you're going to get your money back.

Still, owning Treasuries at today's prices can be costly. The combination of a fearful market and a rate-slashing Fed has already spurred their dramatic rally for Treasuries, and their yields have already plummeted to their 2003 lows. With the five- and 10-year Treasury notes yielding in the neighborhood of 2.5% and 3.5%, respectively, the threat that inflation could erode all if not most of these bonds' returns in the future is a real one. By comparison, 5.7% yields on fixed-rate, 30-year agency mortgage bonds look like a compelling alternative for little added credit risk.

Admittedly, we don't know when liquidity will return to the bond market, and it may take some time for these value-oriented managers' moves to pay off. Still, mortgages have long played an important role in diversified bond portfolios, often providing protection when other sectors, such as corporate bonds, struggle. While some of the dicier mortgage bonds have led to disappointing losses at certain funds during the course of the credit crisis, we think managers who are making calculated, risk-conscious bets today on some beaten-down mortgage issues could be setting the stage for strong returns in the future.