ARM-related funds give yield with low volatility

If you're one of the many people who replaced a high fixed-rate mortgage with an adjustable-rate mortgage (ARM) to take advantage of falling interest rates in recent years, you're probably glad you did.

But what if you bought shares in a mutual fund that has invested in securities collateralized by ARMs?


You may be less pleased with your decision -- thus far.

ARM interest rates are reset at intervals of a year or less -- within limits -- on the basis of the fluctuating rates for short-term U.S. Treasury securities or certain indexes reflecting other short-term rates. The frequencies of the resets vary.


ARMs were introduced during the late 1970s to encourage home purchases by people reluctant to take out 25-year mortgages that had high, fixed interest rates until they were paid off.

Billions of dollars worth of ARMs were later bunched into pools to be used as collateral for newly created mortgage-backed securities (MBS) whose interest payments and principal repayments were guaranteed by the Government National Mortgage Association (Ginnie Mae). This meant backing by the full faith and credit of the U.S. Treasury.

ARMs worth even more billions collateralized securities that are guaranteed by the Federal Home Loan Mortgage Corporation (Freddie Mac) and Federal National Mortgage Association (Fannie Mae), both stockholder-owned corporations that operate under government charters.

To try to maintain relative stability of net asset values (NAVs) and above-money-market yields, ARM fund managers have pursued a variety of strategies that would enhance income or reduce risk, such as the following:

* Changing their portfolios' composition. When interest rates are expected to rise, they raise the proportion of ARM securities whose rates are reset more frequently, aiming to soften the effect of higher rates on NAVs and to benefit from higher yields.

When rates are expected to slide, they emphasize securities with less frequent resets and try to minimize the risk of prepayments by scrutinizing ARM pools to find mortgages less likely to be prepaid.

* Investing in very volatile interest-only (IO) stripped mortgage securities when higher rates are anticipated.

* Shopping for good values. Benham's Randall Merk says he gets better prices by agreeing with lending institutions to buy their new ARM securities while they're being created.


* Investing in other debt instruments, such as higher-yield non-government-related ARM securities and fixed-rate mortgages.

It was the Federal Reserve Board's July 2 reduction in the discount rate that tripped several managers. Anticipating a firming of business conditions and of short-term interest rates, they had restructured their portfolios accordingly and bought IOs. When the Fed eased, mortgage prepayments increased and IO prices fell.

What now?

Franklin Group co-manager Tony Coffey says he expects short-term rates to continue slipping for now but to rise after the November elections. In line with that outlook, Franklin has been reducing the portfolio's holdings of ARM securities that do better when rates decline.

# 1992 Werner Renberg