I read an article from the Fall/Winter 2011 Edition of American Funds Investor Magazine and want to share some of the information I found beneficial.

When Congress created the Government National Mortgage Association (Ginnie Mae) over four decades ago, the goal was to expand affordable housing by linking global capital markets to the nation’s housing market. Lenders pooled individual mortgage loans to create securities that were guaranteed by Ginnie Mae and then sold them to investors. Since that time, two other such enterprises, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), began issuing mortgage-backed securities with the implicit backing of the government. Today, everything from 30-year fixed-rate loans to adjustable-rate mortgages have been pooled into such securities, which together account for about one-third of the total bond market.

But after the turmoil in the housing market over the past several years, some question why they would want to invest in this sector. Wesley Phoa, principal investment officer for American Funds Mortgage Fund, which was introduced last year in the midst of the housing downturn, says the market is much broader and more conservative than some investors may think. We spoke with Wesley to get his thoughts on investing in mortgage-backed securities and the role a mortgage fund can play in a diversified portfolio.

Why would someone invest in this sector?
The purpose of this fund is to provide current income and preservation of capital. It is designed for that part of an investor’s portfolio where preservation is critical. For example, it is a sensible option for precautionary “rainy day” savings or as the part of a retirement plan where it’s important to protect principal.

Why start a mortgage fund in the midst of the worst housing crash in generations?
We don’t try to time the market when introducing funds. Instead, we look at what the investor need is, develop a fund objective to meet that need and then decide what types of investments would be most appropriate. Our goal here was to create a portfolio that can allow investors to generate current income while preserving principal, and mortgage-related securities happen to fit the bill. Whether we introduce a fund during a favorable or unfavorable environment does not really matter. The fund is designed to be part of investors’ portfolios for the long term.

What is the biggest misperception about the mortgage securities market?
Some investors believe that because the housing market is in terrible shape, they will lose money investing in mortgages. But it’s a mistake to paint the mortgage securities market with the same brush as the housing market.
Residential mortgages are a $10 trillion market. To put that in perspective, that’s about the same as the market cap of the unmanaged Standard & Poor’s 500 Composite Index. Because of its sheer size, the mortgage market cannot exist without conservative and highly liquid investments. Even in 2008, while mortgage-related securities backed by the government declined during the year, they made all their scheduled interest and principal payments, and prices more than fully recovered by year-end. The market remained liquid and investors earned a positive return. In fact, government-backed mortgages were up over 8% in a year when the S&P 500 was down 37%.*

What is your process for choosing investments?
We start by considering only AAA-rated bonds, but we would never make an investment decision based solely on the rating. We make an independent judgment based on our own research.
As part of this research, we seek input from our mortgage analysts who specialize in this area of the market and those bonds specifically. We also gather input from fixed-income and equity analysts who cover other companies in the mortgage value chain, such as banks, major mortgage servicers and homebuilders.

How do macroeconomic factors affect your investment decisions?
We weigh what our economists and political analysts are telling us about the housing outlook and regulatory developments. We also speak with our accounting analysts about the impact of accounting factors on the behavior of major participants in the mortgage business.
In addition, we look at what is going on in the broader securities market. The behavior of issuers and investors—and how it is influencing supply and demand—can have a large impact on valuations.

How concerned are you about the potential of rising interest rates?
The basic rule applies to all bond funds: If bond yields go up, prices go down. However, it still makes sense to own bonds as part of a diversified portfolio. Investors should not be focusing on whether prices will go down in a particular scenario, but whether the objective of the fund makes sense in the context of their overall investment plan. Most investors are balancing a need for growth, income and capital preservation. To achieve this in different environments as both stock prices and interest rates are fluctuating, they need to own an appropriate mix of stocks and bonds.
It’s also important to remember that, as investment managers, we constantly evaluate which kinds of interest rate scenarios are more or less likely and make active decisions about how to position the fund in various scenarios.
Finally, investors should not forget that they are still earning a coupon, which helps to offset the impact on price when interest rates rise. And when you own mortgages, principal comes back to you that can then be reinvested. When interest rates are rising, you’re reinvesting at higher yields. So it’s helpful for our income objective when bond yields don’t remain at extremely low levels for long periods of time.

What is your outlook for the housing market?
It’s going to take the housing market a long time to recover, but the pace will largely depend on the region. Bubble states like California, Arizona, Florida and Nevada are likely to remain in a slump for an extended period. Other states could actually experience housing shortages, and a recovery could occur more quickly than expected. Also, note that housing doesn’t have to recover for mortgage-related securities to deliver good returns. In fact, some investments will actually do better in a stagnant housing market.

What changes do you expect in the mortgage market over the next few years?
There are radical changes under way, and I expect it will take the industry a long time to adapt. Those changes include the way mortgages are underwritten, the kinds of due diligence that must be done on potential borrowers, the procedures to foreclose on borrowers and the way that servicers are paid.
Additionally, numerous regulatory and legislative developments have been initiated that are likely to have a profound impact on the mortgage market, although it’s too early to know exactly how. A major focus of our current research is to understand what the different options are so that we will know how to position ourselves going forward.

*According to the Barclays Capital Government/Mortgage-Backed Securities Index. Past results are not predictive of results in future periods.

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