Morgage-Backed Securities Funds

These funds invest in mortgage-backed securities that represent interests in
pools of residential mortgages. The most popular mortgage-backed securities
fund is the GNMA fund, which holds mortgage "pools" that are backed by the
Government National Mortgage Association (which in turn is backed by the full
faith and credit of the U.S. Government). Mortgage pools represent individual
residential mortgages that have been purchased and "packaged" by a
government agency, before being resold to investors as a single security. Each
month, the holder of the mortgage pool - in this case the fund - receives an
interest income payment as well as a portion of the principal from each
underlying mortgage.
Morgage-Backed Securities Funds

As in the case with other bond funds, mortgage-backed funds are subject to
interest rate risk. But these funds are also subject to prepayment risk. That 
is, when interest rates decline, the total returns of the mortgage-backed 
funds may lag behind those of other bond funds, since many homeowners will 
refinance their mortgages at the new lower rates and pay off their old 
mortgages. As a result of this incremental risk, the yields on mortgage-backed
funds tend to be higher than those of funds that invest solely in U.S. Treasury
or government securities.