ARM funds for safety and yield.

• Author: Anderson, Alexander M.
• Position: Adjustable rate home mortgage security mutual funds

During the past decade, individual investors seeking to combine acceptable yields with safety for fixed-income portions of their portfolio found refuge in short-term government bonds or CDs. With yields typically 8 percent or higher, there was little reason to look elsewhere. But with the interest-rate freefall in the last several years, bond rates have dropped, and a steepening yield curve has left cautious investors scrambling for ways to secure returns above the inflation rate.

The answer may be the adjustable rate home mortgage security (ARM), a relative newcomer in the financial marketplace that has exploded into a $100 billion market in less than five years. As a symptom of the growing popularity of ARMs, the number of ARM mutual funds increased from nine in August 1991 to 32 as of the last count (May 1992).

HOW ARMS WORK

Here's how ARMs work: Banks make adjustable rate mortgage loans and typically sell them to government agencies such as the Government National Mortgage Association (GNMA or Ginnie Mae), the Federal National Mortgage Association (FNMA or Fannie Mae), or the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac). The agencies collect the loans in pools by geographic area, loan rate, and maturity. ARM investors buy into the pools and, in exchange, receive a share of the monthly interest and principal payments made by the homeowners.

What makes ARM pools attractive? First, they typically have the backing of the U.S. government or its agencies, so risk of default is extremely low. (There are some exceptions, however, which I explain below.) Second, the pools are traded on the open market, and so are liquid. Third, yields range from 100 to 200 basis points higher than short-term Treasury notes, and sometimes even exceed the rates on 30-year Treasury bonds. Finally, since ARM rates adjust as interest rates change, ARM market prices tend to be more stable than those of intermediate or long-term fixed-rate bonds.

WHY NOW?

ARMs are particularly appropriate in the current economy, when short-term yields are low but are beginning to move up again as the economy improves. When short-term interest rates are low, ARM yields are much higher than many money-market alternatives, such as Treasury bills and CDs. They are also competitive with intermediate-term securities, and will do better than intermediates if interest rates climb, as we saw in the first four months of 1992. Rising interest rates in the bond market caused the...