Monday Morning: Mortgage securities a haven for investors?

When investors lose confidence in the stock market, they often switch at least part of their assets to fixed-income investments.

When that happens, the conventional advice is for the investor to “buy the market.”

Claude B. Erb, managing director at the Trust Company of the West in Los Angeles, disagrees with the conventional wisdom. He advises investing in mortgage-backed securities. He bases his opinion on his company’s research.

Three primary fixed-income sectors are attractive to most investors: the Treasury and agency sector, the corporate sector and mortgage-backed securities.

“The only reason to invest in governments,” says Mr. Erb, a member of the team that manages the TCW Multi-Strategy Fixed Income Fund, “is because you are betting interest rates are going to go down.

“But most people have no idea where interest rates are going, because this is a bet on inflation. Predicting interest rates is a mug’s game. [And] the only reason to be in corporates [i.e., corporate bonds] is because you enjoy the pain,” he adds. “The major driver of return is yield.”

The case for investing in fixed-income securities rests on two goals, he says: to earn a return greater than can be earned in cash, and to do so with the least risk.

From 1976 to 2002, the mortgage-backed-securities sector grew faster than any other, at an average of 21.4% per year. Treasuries grew by 10.8% per year, agencies by 10.32% per year and the corporate-bond sector by 9.9% per year.

First in assets, too

As of March 31, the value of mortgage-backed securities outstanding was $2.8 trillion, compared with $1.9 trillion for corporates, $1.5 trillion for Treasuries and $849 billion for securities issued by government agencies.

Examining the annualized returns from December 1988 to May 2002, Mr. Erb and his colleagues at TCW found that the three largest sectors of the bond market performed virtually identically.

According to their respective Lehman Brothers indexes, governments returned 8.1%, mortgage-backed securities 8.4% and corporates 8.6%.

The risk, as measured by standard deviation of return, was, however, significantly different.

Mortgage-backed securities were the least risky.

The standard deviation of return for mortgage-backed securities was about 3.4, compared with 4.25 for governments and 4.7 for corporates.

Mortgage-backed securities also have the lowest duration (another measure of risk) of the three.

In addition, says Mr. Erb, mortgage-backed securities have most consistently outperformed cash. Over rolling one-year periods from December 1988 to May 2002, they outperformed cash 82% of the time, compared with 72% of the time for corporates and 70% of the time for governments.

When bond markets fell, mortgage-backed securities declined less than governments or corporates – down 6% on average, versus losses of 11% and 10.3% for corporates and governments, respectively.

On the other hand, mortgage-backed securities went up a little less in rising markets – an average of 13.6%, versus 15.9% for corporates and 14.8% for governments.

So mortgage-backed securities beat cash most consistently and with the least risk, the key objective of fixed-income investment. Why, then, do mortgage-backed securities get so little notice?

unknown investment

Mr. Erb says lack of familiarity is the problem.

Investors may not know what they’re investing in when they buy governments, but they know the word “government.”

Likewise, they hear about corporations all the time, so they feel familiar with corporates. People almost never hear about mortgages, except when they are refinancing, Mr. Erb says.

Mortgage-backed securities may be the Rodney Dangerfield of fixed-income investing. Perhaps it’s time they got some respect.

Mike Clowes is the editorial director of InvestmentNews and sister publication Pensions & Investments.