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Christine Benz : Hi, I'm Christine Benz for Morningstar.com. Mortgage-backed bonds make up a huge percentage of the bond market, but they may be less familiar to bond-fund investors than corporate bonds or Treasuries. Joining me to discuss these securities is Eric Jacobson. He is director of fixed-income analysis with Morningstar. Eric, thank you so much for being here. Eric Jacobson : I am glad to be with you, Christine. Benz : Eric, let’s start by just giving people a basic overview of these bonds and the logistics of how they work. Jacobson : Sure. Well the key thing to understand is that mortgage-backed securities, as we call them really, are collections of mortgages that are typically pooled together and bundled into securities. And the thing to understand is that they can run the gamut in terms of complexity, depending on how you slice and dice those securities once you create them. That’s one of the reasons why, as you suggested, people may not be as familiar with them because the way this market works tends to be very targeted toward institutions. Benz : So Eric, what are the key flavors of mortgage-backed securities that investors should be aware of? Jacobson : Well the largest chunks of the market are going to be mortgages that are backed in one way or another by the government. So historically we would be talking about Ginnie Mae mortgages, as well as Fannie Mae and Freddie Mac, which were essentially assumed to be backed by the government. Nowadays, the way that things have gone ever since the financial crisis, Fannie Mae and Freddie Mac mortgages are even more explicitly backed in some ways than they used to be. But essentially you are talking about these three agencies forming the bulk of issuance now in the mortgage market. There are still outstanding a lot of mortgages that were issued and created that were never bundled up and guaranteed by those agencies that were essentially structured in different ways to provide security. People may remember that’s a big part of the market that blew up during the crisis, but there is a lot of that stuff still outstanding. You don’t find it in that many mutual funds, but those that buy it find a lot of opportunity there because of the fact that demand has been so low for that section of the market. Benz : So in general that part of the mortgage-backed security market that is not backed either implicitly or explicitly by the government, that’s the riskier piece, generally speaking, even though I am sure managers would argue that there are higher quality securities within that grouping? Jacobson : Exactly. I think, the underlying collateral is from the types of loans that ran into trouble most during the crisis. As you say managers will argue today that because their prices are so depressed and they are essentially being marked at fire-sale levels, they are actually not that dangerous, which is a pretty compelling argument. But the fact of the matter is that because they are not government-backed and guaranteed, for those kinds of reasons you don’t find them in the core sections of most portfolios today. Benz : So let’s talk about the pervasiveness of these bonds in bond-fund portfolios. Obviously there are funds that are specifically named Mortgage-Backed Securities that have a specific targeted focus on this sector. But how about within the typical, say, intermediate-term bond fund, how big a role do mortgage-backed securities typically play? Jacobson : Unless a manager has a particular focus most will have a decent-sized portion of their portfolio in mortgage-backed securities, if for no other reason than that they don’t want to diverge too much from the Barclays U.S. Aggregate Bond Index, which despite all the name changes is still sort of the lodestar for the bond-fund market. Benz : Another grouping that I'd like to look specifically at would be the Ginnie Mae-focused funds. A lot of investors have a lot of money in these funds. Vanguard's Ginnie Mae fund is one of the biggest out there. This has really been a tremendously performing fund, a great asset class overall. I'm wondering if you could discuss what has helped returns in the past and also any risk factors that investors should have on their radar. Jacobson : Well, the one thing that has helped the most in the last year in particular, when you go back to 2011, is that the quality is so high because they are explicitly backed by the U.S. government that, Ginnie Mae mortgages did even much better than Fannie and Freddie Mac mortgages during the rally last summer. And for the year as a whole, they looked a lot better in returns. And part of the reason was, I think, that there were questions about different kinds of programs that might affect Fannie Mae and Freddie Mac and might drive up prepayments a little faster than the market was expecting, so they lagged a little bit partly for that reason. But by and large as I said, because of their relationship to Treasuries, having such high quality and having that extra bit of income that's associated with the option for investors to prepay, and because of that option for investors to prepay their mortgages, that's why mortgages tend to yield more than Treasury bonds. But you bake all that together, and they did really well last year. Benz : So with Ginnie Mae funds, obviously credit sensitivity is not an issue because these bonds are backed by the explicit guarantees of the government. But how about other risk factors that investors should be attuned to? Jacobson : Well, the big ones going forward most likely revolve around interest-rate risk because what happens when rates rise is that the rate sensitivity of mortgages tends to go up. One factor that could be an issue at some point going forward, but hasn't been lately, is also prepayment speeds because if homeowners are able to refinance more quickly than they have been in the past, which the levels in the last couple of years have been very, very low, that can take down mortgage prices too. Benz : So, Eric, let's talk about interest-rate sensitivity. That's something that's top-of-mind for bond investors these days. Let's discuss the interplay between rates and the mortgage-backed sector. Jacobson : Well, that's one thing I think that's really important for people to take into account, is that the way mortgages trade such that if interest rates do start to go up, they will become more sensitive to rates as rates rise. So, I'm not necessarily trying to sound a warning bell that people need to be worried or that this is on the horizon immediately. But people should understand that despite the fact that mortgages have performed so well in some of the other environments that we've had up until now, there is a potential for them to be pretty sensitive to rising yields, if and when they really do start to spike in a sustained way. Benz : Now, are there parts of the mortgage-backed market that you typically think of as being particularly rate-sensitive and other parts that are less sensitive to changes in interest rates? Jacobson : Well, normally speaking the lower-coupon issues, and when I say lower coupon I mean those with smaller interest rates, tend to be the most sensitive to rising yields because they have the most to lose because they are delivering less income. The fact is that over the last few years the way that issuance and refinancing has gone and so on and so forth, that is a big, big chunk of the market in those small-coupon or low-coupon mortgages. Benz : So would you say that the securities that are backed by the explicit or implicit faith of the government would tend to be, generally speaking, more rate-sensitive because they would have lower coupons attached to them? Jacobson : That’s right. You’d break it down a little more once you are dealing in the minutia of a portfolio and looking at different maturities, and certainly the longer-maturity mortgages are going to be more susceptible to rising rates than the shorter ones. But that’s exactly right. The higher the quality, the lower the coupon, the lower the yield, and the more sensitive you are normally going to be to rising yields. Benz : Last question for you Eric. I’d like to talk about what role these bonds might play in a portfolio? I know a lot of investors do have dedicated mortgage funds and they might also have intermediate-term bond funds. My question is would these tend to be redundant or does it depend on what’s in that intermediate-term bond fund? Jacobson : I think a lot of people understandably might want to supplement a core fund, even one that does have mortgages, if they are trying to really derisk a portfolio and by that I’m talking about long-term volatility risk associated with stocks. It's not necessarily something that people want to do today because they think that bonds are priced so high and yields are so low, but we have seen that trend in cash flows of money moving out of stocks and into bonds. And if that's the case you're going to have, all things being equal, a little bit less risk in a mortgage fund than you will in a diversified core bond fund that’s going to have corporates in it as well as potentially some nonindexed sectors, such as nonagency mortgages or commercial mortgage-backed securities and things that tend to trade-off when the market goes badly. Benz : Eric, thank you that's really helpful context and thanks for shedding insight into this category, which some investors don't know a whole lot about. So thank you for joining us. Jacobson : I’m glad to do it. Thanks for having me. Benz : Thanks for watching. I’m Christine Benz for Morningstar.com.