Mortgage Funds Dodging Subprime Bullet

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This configuration helps to diversify risk; however, it's difficult to sell the senior-tier securities before unloading the lower-tier assets. When this process is applied to pools of subprime mortgages (or any mortgage pool, for that matter) and the quality of the underlying mortgages deteriorates, the lower tranches in the structure become much more vulnerable to loss.

Slow Deterioration Forecast

Jeffrey Gundlach, the chief investment officer of TCW Group and manager of the TCW Total Return Bond fund (TGLMX), believes some perspective is necessary. Gundlach, whose fund has no credit exposure to subprime assets, notes that the recent rise in delinquencies among risky mortgage owners has not been dramatic, but likely presages a long, slow-moving period of deterioration. "Subprime delinquencies were at 13.3% in the fourth quarter of last year," he says. "But two years ago, that figure was at 10.6%; that's really not such a big jump. Subprime has been notorious for systematic ongoing delinquencies."

Bondholders exposed to high-quality agency-issued mortgages have nothing to worry about, Gundlach says. "I've told people for years that our Total Return Bond Fund has no credit risk. We have no subprime mess to clean up. I also see no spillover into the high-quality prime mortgage market from these subprime defaults."

Gundlach warns that the subprime delinquency rates are probably headed higher, a process that will unfold over the long term. "There are many issues still at play, including many payment re-sets still to come," he says. "Subprime loans have much shorter reset periods—in general, a few months to a few years—than do prime loans. Subprime loan holders will either have to default or seek to refinance, which many of them won't be able to do."

Long Road to Foreclosure

Adding to the gloom, S&P credit analysts Michael Stock and Scott Mason forecast that cumulative losses on subprime-backed bonds issued last year will amount to between 5.25% and 7.75%. "If the country experiences a recession, or if home prices fall dramatically, losses may exceed the 7.75% threshold," they wrote in a recent report. (S&P Ratings Services operates separately from S&P Equity Research.)

However Milton Ezrati, senior economic and market strategist at Lord Abbett, cautions the subprime market may represent up to 15% of all new mortgages, but in terms of dollar value, they account for only about 1% of all outstanding mortgages. Moreover, it takes a long time for properties to be foreclosed. Ezrati estimates that in the unlikely event all delinquent subprime loans entered foreclosure, the loss would amount to just 0.3% of the dollar value of all outstanding mortgages.

Ezrati believes the high level of securitization of subprime mortgages may actually protect investors by spreading risk. "By taking those inherently risky loans off the books of lenders and generalizing them throughout the investment community, securitization reduces the chance of bankruptcy," he notes. "Instead of a few lenders losing all, many people lose a smaller portion on their assets."

Surviving the Tumult

As for bond fund holders who find they have significant exposure to subprime loans, Gundlach believes they have few options. "There's nothing magical about subprime mortgages that distinguishes them from other kinds of debt," he says. "They are somewhat analogous to junk bonds. You can sell them at a loss, hold them because you're stuck with them, or you can buy more because you think it's overdone on the downside."

Thus far, mortgage bond funds appear to have survived the tumult. The Lehman Brothers Mortgage-Backed Securities index gained 1.6% in the first quarter of 2007. By comparison, the Lehman Brothers U.S. Aggregate Bond index—a proxy for the U.S. fixed-income market—returned 1.5% over that period.

Other mortgage bond funds include Pimco Total Return Mortgage (PTMDX), Huntington Mortgage Securities (HMTGX), Pimco GNMA (PGNDX), and Vanguard GNMA (VFIIX).

Ghosh is a reporter for Standard & Poor's Fund Advisor.