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Getting Fatter Yields With Mortgage ETFs

Tickers in this article: VMBS MBG MBB SCCYX
New York ( TheStreet) -- Struggling to find more income, investors have been pouring into high-yield bonds, which yield 6% or more. That's a nice payout at a time when 7-year Treasuries yield 1.03%.

But high-yield bonds come with plenty of risk. If the economy slips, the bonds could sink. To pick up a bit of extra yield without taking on much risk, consider mortgage exchange-traded funds.

A popular choice is iShares Barclays MBS Bond (MBB) , which yields 2.36%. Other funds that yield a bit more than comparable Treasuries include SPDR Barclays Capital Mortgage Backed Bond (MBG) and Vanguard Mortgage-Backed Securities Index ETF (VMBS) .

In normal times, mortgage securities come with important risks. If interest rates swing sharply, the securities can suffer losses. But the current mortgage market is hardly normal. Trying to stimulate the economy with its third round of quantitative easing, the Federal Reserve has been buying $40 billion of mortgages each month. That has made mortgage ETFs safer. As long as the Fed keeps buying, mortgage prices are not likely to drop suddenly.

What happens when the Fed stops buying mortgages and begins raising interest rates? Mortgages can sink sharply when rates rise, warns Mark Egan, portfolio manager of Scout Core Bond (SCCYX) , a mutual fund.

As recently as February 2011, rates on 10-year Treasuries topped 3.60% before dropping to today's level of 1.61%. Egan worries that rates could swing sharply back to their former levels.

"If rates go back to 4%, a lot of investors would be shocked by the price declines of mortgages securities," he says.

Fed Chairman Ben Bernanke has said that he plans to hold down rates for the next several years. But Egan cautions that the central bank could change course suddenly. If the economy starts rebounding 18 months from now, the Fed could raise rates sharply.

Still, it seems unlikely that the Fed will increase rates for the next year or so. That should provide an ideal market environment for mortgage ETFs, which tend to outperform Treasuries during periods of flat or slightly rising rates.

The funds hold a variety of mortgage-backed securities that are sponsored by agencies such as Fannie Mae (FNMA) and Freddie Mac (FMCC) .

The securities represent pools of home mortgages. As homeowners pay principal and interest, the cash is passed along to investors in the securities. Some of the agencies nearly collapsed during the financial crisis. But they were taken over by Washington. As a result, the mortgage securities now have negligible default risk.

Although they cannot default, the mortgages provide extra yield because they come with the risk of prepayments. These occur when homeowners refinance or sell homes and pay off mortgages.