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Refreshing returns in the mortgage pool

Fans of fixed interest will find better yields in securities backed by home loans, bond guru Bill Gross tells THERESA EBDEN

When one of the world's top bond investors has a hard time getting excited about yields on government notes this year, some might say we shouldn't get our hopes up for bond funds.

But Bill Gross, who heads the $90-billion (U.S.) Total Return Fund for Pacific Investment Management Co., says he sees a good opportunity in the mortgage debt market, which is often overlooked by the average retail investor.

"It's a little frustrating for fixed-income investors -- they say, 'Where can I get a better yield?' " Mr. Gross said from his office in Newport Beach, Calif. "The safest way is to buy the mortgage market. . . . There's a decent yield at this time."

That's why he says smart investors will turn to funds that hold a high percentage of mortgage-backed securities, bonds backed by pools of mortgage loans.

Instead of paying investors fixed coupons and the principal at the end, mortgage backed securities pay out cash from the underlying mortgages. Each payment represents a partial repayment of principal along with interest.

Bond fund managers have been hungry for higher yields amid an inversion of part of the U.S. Treasury yield curve, which occurred as bond yields on some longer-dated government notes paid less than those of shorter ones.

Some bond funds are venturing further into the mortgage market as the average mortgage bond yields about 5.5 per cent -- roughly one percentage point more than the average Treasury yield. The return on mortgage securities is higher because of the risk of prepayment by homeowners, which results in investors getting their initial principal back earlier than planned.

Mr. Gross expects the mortgage market to boost returns in bond funds this year.

Among the securities counted in the mortgage market are those of three large U.S. bodies. There's the Government National Mortgage Association, a government agency known as Ginnie Mae, and two government-sponsored enterprises: the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corp. (Freddie Mac).

Private companies also sell mortgage-backed securities. In all, mortgage securities represent the largest segment of the U.S. bond market, at about 23 per cent, according to PIMCO.

On this side of the border, managers of bond mutual funds looking for Canadian equivalents will often hold Canada Housing Trust bonds. Sales of these securities are overseen by the treasurer of the Canada Mortgage & Housing Corp., a body that provides the trust with some financial-advisory services. The amount outstanding for these bonds is about 1.5 per cent the size of the U.S. mortgage-backed securities market, Mr. Gross estimates.

The liquidity of the Canadian securities isn't as high as that of government bonds, but still is "not bad," Mr. Gross added.

Everyday investors shopping for a bond fund should look for mortgage-market securities in the list of holdings, Mr. Gross says.

"There are several ways to play it. One would be in some of these floating-rate, closed-end funds that have been issued in the last year and a half and have currently very attractive yields but have suffered in price because that's what happens to closed-end funds after they're issued -- they go to discounts," he said. Among the options Mr. Gross recommends for retail investors looking for mortgage exposure is a product put out by one of his firm's competitors, BlackRock Inc. The BlackRock Global Floating Rate Income Trust is closed-ended, meaning it's not continuously offered to buyers after a public offering. Instead, shares are traded in the open market, currently at about 6.95 per cent.

"You may wonder how in the hell it can offer a 6.95-per-cent yield, and . . . the mortgage market offers (about) 5.60 per cent," he said. "Part of the reason is the closed-end funds have a mild amount of leverage. They borrow through the preferred market and invest in a higher yielding mortgage."

This introduces some risk to investors, because if borrowing costs go up, margins get squeezed for the closed-ended funds, he said. Mortgage-backed securities themselves have a relatively low credit risk yet are attractive because their yield typically exceeds that of investment-grade corporate bonds with similar maturity dates.

For any securities connected to residential mortgages, a risk factor to investors is prepayments. Homeowners often refinance when interest rates fall, and these prepayments return principal to investors when options for reinvesting those funds may be less attractive.

Investors seeking funds with a great deal of mortgage holdings won't find a wide selection, especially in the close-ended arena, Mr. Gross said. Even so, mortgage bonds are attractive, he added, because they focus on the front-to-middle end of the yield curve, where he sees less risk in 2006.

Mr. Gross isn't as enthused about the returns for many corporate bond funds, though of those he oversees, he likes the PIMCO Corporate Opportunities fund, which consists of both investment-grade and non-investment-grade bonds and yields 9.72 per cent on the New York Stock Exchange.

Theresa Ebden is an associate producer for Report on Business TV.

Canadian bond funds in 2005

Funds ranked by average annual returns as of Dec. 31, 2005

Top 20 funds

FundNet assets ('000)One-year returnFive-year return
SEI Long Duration Bond Fund$107,752 +18.30%n/a
Dynamic Real Return Bond Fund81,875+17.8n/a
SEI Real Return Bond Fund140,165+14.1n/a
Beutel Goodman Long Term Bond Fund30,163+13.6+10.10%
Altamira Bond Fund252,307+11.2+7.6
Renaissance Cdn. Real Return Bond Fund60,076+11.1n/a
TD Real Return Bond Fund2,594,409+11.0+9.3
Mulvihill Canadian Bond Fund39,306+10.8+7.1
Mackenzie Sentinel Real Return Bond281,388+9.7n/a
CI Long-Term Bond Fund134,767+8.4+6.5
Investors Real Return Bond Fund76,967+7.9n/a
Quadrus LLIM Income Plus Fund46,605+7.1+6.4
Beutel Goodman Corporate/Provincial Active Bond Fund5,583+7.0+8.1
GBC Canadian Bond Fund53,223+6.7+6.5
SEI Income 100 Fund93+6.6n/a
SEI Canadian Fixed Income Fund1,381,912+6.5+7.2
Phillips, Hager & North Total Return Bond Fund898,176+6.5+7.4
United Canadian Fixed Income Pool1,292,609+6.4+7
TD Canadian Bond Fund6,702,116+6.4+7.3
Phillips, Hager & North Bond Fund995,014+6.4+7.2

N/A = not available.

Per cent returns are average annual compound returns as of Dec. 31, 2005.

Calculations assume reinvestment of distributions.

SOURCES: TILLY CHEUNG / GLOBEFUND.COM AND PIERRE JAVAD / GLOBEINVESTOR.COM

© 2007 The Globe and Mail. All rights reserved.

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