Investing in mortgages

October 17, 2008

Considerable rewards await those who invest in mutual funds that hold packages of principally higher-than-subprime-quality mortgages.

Key Points

Everyone has heard for months about the fallout from the subprime mortgage mess, including a decline in home prices and an increase in the number of home foreclosures. So the idea of buying mortgage-backed securities might sound as appealing to you as playing in traffic.

Let me assure you that I have no intention of recommending you play in the dangerous streets of subprime mortgages. But considerable rewards await those who invest in mutual funds that hold packages of principally higher-than-subprime-quality mortgages.

Mortgage-backed securities are mortgages pooled together with the homes serving as collateral. The securities are sold to investors as bonds, with part of the principal and interest paid back monthly from the cash flow of monthly mortgage payments. These securities have been tarnished by the subprime brush, leading to a sharp decline in their prices.

Mortgage-backed securities are bundled together by quality (and often also by issue date and, perhaps, by due date) and sold into the market as one big package. The common action of pooling these mortgages and then chopping them up into tiers of quality is called "tranches." These securities are not made up of subprime mortgages. Those who limit their buying to selected packaged securities of mortgages, held by people who have high credit scores and have been rated on the more stringent standards since September 2007, assume less risk and can look forward to potentially high returns-especially if they invest in senior tranches, which have subordinated tranches to absorb any declines.

Many of these mortgages are currently selling at a discount. But the people who owe money on high-quality mortgages often have put down payments of 10 or 20 percent of the purchase price of the home. In some cases, they already have prepaid down some of the mortgage, which makes them safer.

The real-estate price drops are likely to moderate sometime next year to the point where the declines may be largely over by as early as June.

Nonetheless, be careful in buying these securities on your own. Wise investors should limit themselves to purchases through an adviser who is familiar with the mortgage market and who concentrates on high-quality securities. The approach I would recommend is to invest in high-quality bond mutual funds whose knowledgeable managers thoroughly understand the market.

Two such funds are Pimco Total Return (PTTDX) and TCW Total Return (TGMNX). Both are rated very highly by Morningstar, invest principally in higher-than-subprime-quality bonds, and have begun to load up on high-quality, mortgage-backed securities. Both have other types of bonds in their portfolio as well. If you share my confidence in funds such as these, you stand a good chance of profiting from the coming change in the investment environment.

The author, a fee-only financial planner, is president of L.J. Altfest & Co., a financial and investment advisory firm in New York City, and an associate professor of finance at Pace University. The ideas expressed in this column are his alone and do not represent the views of Medical Economics. If you have a comment or a topic you'd like to see covered here, please e-mail meinvestment@advanstar.com
.