Refinancing Hits Bond Funds

The decline in interest rates on home mortgages has helped homeowners, but not consumers who own shares of mutual bond funds that have invested in securities that are backed by pools of residential mortgages. Both the Government National Mortgage Association (GNMA) and Freddie Mac guarantee payment of principal on a large portion of these mortgages. Just in the past eight months of this year, GNMA took in $9.8 billion from investors. However, in response to the decline in mortgage interest rates, homeowners have been refinancing their mortgages. As a result, homeowners are paying back the principal on their existing mortgages many years earlier than the mutual funds holding the mortgages had expected. In short, funds that had been earning 7.6 percent are being returned at a time when they can be reinvested in mortgages earning about 6 percent. In her article in the Wall Street Journal, Karen Damato quotes Paul Kaplan, manager of Vanguard GNMA with $26.5 billion in assets: "Just when you'd like to lock in the interest rate forever, they take it away and give you a lower one."

If the current situation is not sufficiently troubling, think what might happen if interest rates rise when the funds are holding portfolios of low-rate mortgages. Like any fixed-income security, the value of the mortgages in their portfolios would fall, as well as the market value of the fund. It's a tough world out there.