Mutual funds that invest in mortgage-backed securities are wrapping up a banner year.
Battered by interest rate upheaval, these funds have seen roughly $20 billion in outflows since the end of 1993. But this year, assets have begun to creep back up, albeit slowly. Net inflows have totaled $1 billion, boosting assets to $54.7 billion as of Oct. 31, according to the Investment Company Institute, a Washington-based trade group.
The growth stems from a dramatic rebound in performance. Mortgage funds, which posted returns of -4.71% in 1994, produced average returns of 14.59% in the first 11 months of this year. The reason: interest rates have stabilized, alleviating the surge of prepayments that had made mortgage securities so volatile.
Mortgage funds merit the attention of lenders, because the loans they originate are increasingly winding up in such portfolios. As a result, the activities of mortgage funds can markedly affect mortgage pricing.
Mutual funds now account for about 25% of the purchases of mortgage- backed securities, said Louis Harvey, president of Dalbar Inc., a Boston- based fund researcher.
"They are an indicator of public appeal that is watched very closely," Mr. Harvey said. "In recent years, they have become much more of a force."
The mortgage fund managers at Alliance Capital Management - one of the 20 largest U.S. mutual fund companies - are bullish on the mortgage market.
"Mortgages are cheap relative to where they've been over the past three years," said Paul A. Ullman, who co-manages two mortgage funds with Patricia J. Young.
What's more, Mr. Ullman said, mortgage-backed securities are underpriced in relation to the Treasury securities they are benchmarked against.
The two Alliance funds, Mortgage Securities Income Fund and Mortgage Strategy Trust, were up 14.74% and 6.44% respectively through Nov. 30, according to Lipper. Together, they hold $1.5 billion in assets, ranking them among the largest mortgage funds.
The Alliance fund managers have been bulking up on mortgage-backed securities over the past few months, mainly by reducing their holdings of Treasuries. These holdings have been halved, to 10%, while residential mortgage-backeds have been boosted to 80%. Commercial mortgage-backed securities make up the remaining 10% of the portfolios.
Mr. Ullman and Ms. Young are most interested in mortgage bonds whose return exceeds par, or the face value of the bond. The funds are also holding securities that supply a higher return in exchange for a bit more risk of prepayments, in which borrowers pay off their mortgages early.
Ms. Young said she believes the prepayments will not occur as fast as the market is projecting they will, and this will allow the funds to continue posting gains.