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Income from mutual funds and stocks that invest in real estate backed mortgages has never been higher. With returns of 8-15% these alternative investments - when used appropriately - can substantially increase portfolio income and growth. Much of the success of these funds is due to the difficulty that Americans are having refinancing, despite low rates. Hence for those willing to take on some risk, investing in mortgage focused funds and stocks can provide a significantly higher than average return. Here's what you need to be aware of and how to invest in mortgage backed securities.

When Borrowers Can't Refinance, Lenders Benefit

Normally, when interest rates fall there is a huge wave of refinancing. People pay down their old mortgages and get new ones at lower rates. The result is that mortgage investments can suffer from "early repayment." Investors don't lose money, but their investment doesn't last as long as they had hoped.

Today, despite the low rates, people are unable to refinance because their homes have dropped in value. If you or your financial planner believe that homeowners will continue to have difficulty refinancing, then investing in mortgages may be a profitable decision.

Three Ways To Get Started

Here are a few ways to own mortgages, together with their pros and cons. These are roughly in order of complexity, with the easiest to own and least risky presented first.

A Regular Mutual Fund

DoubleLine's Total Return Fund, DLTNX, is a mutual fund run by Jeffrey Gundlach, who Barron's dubbed the Bond King in early 2011. Here's their investment philosophy:

DoubleLine's portfolio management team believes the most reliable way to enhance returns is to exploit inefficiencies within the subsectors of the mortgage market while maintaining active risk management constraints.

The fund returned 8.76% last year, and has an SEC Yield of 7.96% net of expenses.

SEC Yield is a measure of the expected yield going forward of the investments owned by the fund, at their present market values.

This is an easy, simple way to earn returns from mortgages.

A Closed-End Fund

Closed-End Funds trade like stocks, meaning that there is a fixed number of shares that are traded between individuals. This is in contrast with normal mutual funds, where buyers transact with the mutual fund company, with funds growing and shrinking as investors add or take away money.

While closed-end funds are a little bit more exotic than normal mutual funds, they are not new. Closed-end investment funds have been around since the late 1800s.

Nuveen offers closed-end funds such as JLS and JMT that invest in mortgage-backed securities and have returns of 9.5%. JLS owns around $346 million in assets of which $84 million is financed with money they borrow at low rates. This leverage of 25% means that every $3 you own of the fund buys $4 worth of mortgages.

Leverage adds risk, but it also adds returns. As long as interest rates stay low, closed end funds will likely generate high returns.

Mortgage REITs - Getting More Complex

Finally, there are Mortgage REITs, or Real Estate Investment Trusts. These are regular companies that own pools of mortgages and pass through their income to investors.

Unlike normal REITs, these companies do not own property, they own the mortgages on someone else's property. As a result, they are not subject to market movements based on property values, but instead are faced with others risks, such as default risk.

Higher Returns Through Leverage

Many mortgage REITs have dividend returns of 10-15%, and these returns are achieved through significant leverage, sometimes of 5-10X, so they are exposed to much more default and interest rate risk.

In other words, if a mortgage REIT is worth $1 billion, it may actually own $5 billion in mortgage loans. If these loans default, these companies will be in trouble. These companies are much riskier than the mutual funds listed above.

Residential Mortgages

REITs like Annaly Capital (NYSE:NLY) (yield of 13.9%) invest in the safest mortgages, those guaranteed by the the federal government. Although these mortgages are safe, companies like Annaly that use leverage can get hurt if interest rates increase, because their borrowing costs will rise.

Some companies like Chimera Investment (NYSE:CIM) (yield of 15.9%) invest in a combination of guaranteed and non-agency mortgages, which can help them generate higher yields.

Commercial Mortgages - Newer Funds May Be More Stable

Finally, there are Mortgage REITs that specialize in commercial mortgages, such as Starwood Properties (NYSE:STWD) (yield of 9.3%). The best of these, including Starwood, were formed after 2008 and own post-panic mortgages that may be more stable.

Adding Mortgages To Your Portfolio

At the lower-risk end of the spectrum, mutual funds and closed-end funds that invest in mortgages can fit easily into a portfolio. Investments in Mortgage REIT owning companies should be evaluated very carefully. An expert can help. If you don't have one, you may want to find a financial advisor before changing any of your investments.

Current Income for Retirees

Retirees with a low tax bracket can use mortgage investments for current income, perhaps substituting away from corporate bonds or emerging market bonds.

Retirement Accounts for Working Investors

Working investors with a high tax bracket will be best served by holding these in retirement accounts. If you are a conservative, working investor interested in picking up more bond yield in a taxable account, then explore Nuveen's municipal bond funds which use some leverage to get tax free yields of 6-8%.

Your accountant, financial advisor, or financial planner can help you make the right decisions with respect to taxable vs tax-free bonds based on your tax bracket and yields across the fixed income spectrum.

Moderation is Best

Remember, as with all good things, moderation is best. Mortgages are part of a healthy portfolio, but should not come to dominate it. An appropriately diversified investment plan will be wiser in the long run than concentrating on a single asset class that appears very attractive today.

Source: Money Mortgage Investments