Mortgage-backed bonds, usually best purchased in mutual fund form, add a smidgen of diversification to a portfolio and potentially a bit more return than do most other agency bonds. Again, there’s no urgency to add mortgage-backed bonds to a portfolio, but if you have a large fixed-income allocation, a position in mortgage-backed bonds may make sense.
You don’t need agency bonds. Their overall characteristics are similar enough to Treasuries that the substitution of one for the other isn’t likely to make a huge difference in either the risk profile or the potential return of your overall portfolio. If, however, you are a smart bond buyer (which you certainly can be after reading this book!), substituting agency bonds for Treasuries may garner you a few extra bucks.
Generally, you do better with mortgage-backed securities than traditional bonds when prevailing interest rates are stable. They tend to chug along or droop when interest rates begin to bounce.
Given their overall safety, agency bonds tend to be conservative investments and produce modest rates of return. Therefore, you must make sure that the return isn’t eaten up in transaction costs or management fees.
To give you an idea of what the specific agencies are and what they do, I describe here the four largest (and most popular with retail investors): the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), the Federal Home Loan Banks (FHLB), and the Government National Mortgage Association (GNMA or Ginnie Mae).