Battered mortgage bonds may deserve a second look

December 19, 1993|By Orange County Register

It has been a disappointing year for mortgage-backed securities.

In fact, it's been so dreary that some experts are suggesting these bonds as a possible bright spot for fixed-income investors torn between taking risks in volatile long-term bonds or speculative -- and now high-priced -- junk securities or getting paltry returns on secure, cash equivalents.

"Mortgages look extremely attractive for the next 12 months," said Robert Dow of Lord, Abbett & Co. in New York, one of 10

experts polled on the outlook for the bond market.

The panel's consensus fixed-income portfolio called for pruning riskier holdings -- securities that happen to be some of the year's best performing issues, such as long-term and junk bonds. In return, the panel's portfolio showed one-sixth of fixed-income money in cash, the highest level of such safekeeping in the quarterly poll in a year.

"Credit markets are reacting adversely to signs of faster economic growth," said Lynn Reaser of First Interstate Bancorp in Los Angeles.

In times like these, depressed mortgage bonds are worth a look, panel members said.

These securities' modestly high yields, with safety backed by home loans and the U.S. government, have made them -- and mutual funds that concentrated in mortgage debts -- favorites of conservative investors for years. Coming into 1993, mortgage bonds, as measured by Merrill Lynch, had produced total returns (dividends plus price appreciation) averaging 12.4 percent a year during the past decade.

That hot streak ran out this year as the prepayment risk reared its ugly head. The lowest mortgage rates in a generation sparked a home-loan refinancing boom. Retiring older, high-cost mortgages sucked the payout muscle out of many mortgage bonds, leaving investors with falling yields or prices, or both. Through October of this year, mortgage bonds returned just 6.4 percent, vs. an 11.8 percent gain for the overall bond market, according to Merrill Lynch indexes.

But to many panel members, the bad news has created opportunity.

Lower-yielding mortgage bonds -- those with the lowest chances of being hurt by refinancing -- may be the best bet, offering investors an extra 1 percent of yield above 10-year U.S. Treasury issues, said Sherman Russ of Boston-based Pioneer Funds.

However, the enthusiasm for mortgage bonds is not universal.

If rates rise, mortgage-bond prices will suffer along with other bonds. And if the U.S. economy stalls in 1994, rates could again go lower and the prepayment risk caused by refinancing could bite investors again.

This year's refinancing surge has been fortified by new lending programs that make refinancing easier and cheaper, moves that will keep loan payoffs frequent and may further darken mortgage bonds' longer-term appeal.

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