ARM funds for safety and yield.

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 price of 10-year and 30-year Treasury issues to drop 5 percent to 6 percent and total returns to decline by 2 to 4 percent. But most ARM holdings produced positive returns as a result of their automatic interest rate adjustment features.

ARMs are not as attractive an investment, however, during periods when interest rates are falling sharply. When interest rates drop, investors are better served by locking in a fixed rate rather than having a rate that quickly adjusts downward.

MAKING THE INVESTMENT

Investors considering ARM investments should anticipate holding the issue for at least six months, and preferably a year. Over a lesser time, short-term principal price movements can temporarily offset investment income, resulting in loss. Nevertheless, an ARM security is low risk. For example, a two-point increase in interest rates will cause a 30-year bond to lose 18 percent in value. But a two-point rate increase would cause a typical ARM security to temporarily drop in price by only 2 or 3 percent.

NOT ALL ARMS THE SAME

ARMs are complicated offerings, and the investor needs to consider a number of points before taking the plunge. Demand has triggered a surge of new issues, some of which are guaranteed by a non-federal agency issuer, such as a savings and loan. Needless to say, these ARMS are riskier than those guaranteed by a federal agency. And some adjustable rate mortgage securities are so complex in structure that even experienced investors have difficulty untangling them. Collateralized mortgage obligations (CMOs), for example, may have volatility risk profiles many times that of traditional mortgage instruments.

The frequency of ARM rate resets is another consideration. If the rate is adjusted annually, yield may lag behind increasing interest rates, thereby diminishing returns and increasing price risk. So, if you're a conservative investor, you may want to select ARMs whose rates are adjusted frequently, such as monthly.

Finally, an investor who pays more than par value for an ARM may find himself or herself in a pickle if interest rates decline significantly. Mortgage prepayments accelerate when rates drop, and the premium over par value could be quickly lost.

For individual investors, ARM mutual funds are vastly preferable to purchasing individual issues for several reasons. The cost of acquiring blocks of individual issues of even $100,000 in the retail market is extremely high, and the need for diversification is paramount in order to minimize the risk of an unexpected mortgage prepayment. Also, because ARM securities can be complex, management should be handled by investment professionals.

WHAT TO LOOK FOR

Because ARMs issues are so complex, investors considering ARM mutual funds should carefully read the fund prospectus and offering material. You'll want to know if all holdings are government backed, and if the fund buys higher-risk CMOs. You'll also need to know the investment goals of the fund manager. If you are an older investor, for example, you may look for stability of net asset value; if you are young, you may want maximum income.

You should also assess the fund's emphasis on investment flexibility. Can the fund include fixed-rate instruments, or are investments restricted to ARMs? Generally speaking, some flexibility enhances the prospects for attractive portfolio returns. And you'll want to check the size and resources of the fund manager. A manager should have the wherewithal to analyze, monitor, and efficiently trade ARM securities, and a fully dedicated staff of fixed income and mortgage trading professionals.

You should also look for active management. An active manager will attempt to alter the complexion of the fund portfolio as the economic and interest-rate climate changes. For instance, when interest rates decline, investment returns can be enhanced by switching into issues that reset rates less frequently. The reverse is true, obviously, when interest rates go up. The fund prospectus should indicate whether the investment manager's philosophy is active or passive.

Active management is also necessary to protect the fund against prepayment risks. To do this, an experienced manager will assess many factors, such as the age of the ARM pool and the location and size of the mortgages. Newer pools are generally more desirable: homeowners with new mortgages are less likely to prepay. Location is important because if the mortgages are in an area that is experiencing net job-losses, such as New England, prepayments are likely to be accelerated. But in an area such as Florida, with a large percentage of older home buyers, an unusually high number of prepayments is less likely. Finally, the size of the mortgages is important because, even though a pool that contains large mortgages may offer slightly higher yields, unwary investors may discover that if even a few of the large mortgages are prepaid, the effect on the yield could be dramatic.

A DESIRABLE OPTION

ARMs can be rewarding investments that offer significantly higher yields than other fixed-income issues. When the bond markets are doing poorly, ARMs are a desirable option because of their interest rate adjustment feature. Even when rates are not rising, investors may want to counterbalance their traditional fixed-income investments with an adjustable rate mortgage mutual fund to reduce risk without sacrificing current yield.

ARMs are also a fine alternative for IRA or 401 (k) investors who want to move out of guaranteed investment contracts because of their concerns about the quality of the underlying institution. As a GIC alternative, ARMs can offer improved liquidity, better credit quality, and higher yields.