Investing

Understanding GNMAs

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Have I got an investment opportunity for you: mortgage-backed securities. You invest in a pool of mortgages, and—hey, wait, where are you going?

I’m not talking about the toxic securities that almost destroyed the economy in 2008. I’m talking about GNMA bonds, better known as Ginnie Maes. Unlike other MBSes, the principal and interest on Ginnie Maes are explicitly backed by the full faith and credit of the US government. And investors are flocking to them.

This doesn’t mean you can’t lose money on Ginnie Maes. You can, and I’ll explain how in a minute. But first I’ll walk you through how they work and why you might want to have some in your portfolio.

What is Ginnie Mae?

Sounds like the sister to Fannie Mae and Freddie Mac, doesn’t she? In fact, the Government National Mortgage Association is quite different. First, she (okay, it) has always been part of the federal government. Second, it doesn’t buy mortgages or issue MBSes.
Instead, Ginnie Mae is like the FDIC. A mortgage lender takes a bunch of FHA and VA loans and packages them into a security—a bond. In exchange for a cut of the mortgage, Ginnie
Mae then insures the bondholder against default.

This is actually an oversimplification: the FHA and VA insure against default; Ginnie Mae is in charge of keeping the payments coming to the bondholders even when the mortgage is delinquent. In other words, if a mortgage in the bond gets behind on payments, the person who bought the bond will continue to receive principal and interest payments, courtesy of Uncle Sam, right on time.

Sounds awesome, right? Except you, Jane Sixpack, can’t actually buy a GNMA bond, because they cost about a million dollars. But you can buy into a GNMA mutual fund.
Fun with GNMA funds

All of the major brokerage houses offer GNMA funds. Here are a few to get you started:

Fidelity GNMA Fund
Vanguard GNMA fund
T. Rowe Price GNMA Fund

If a fund has “GNMA” in its name, it’s required by the SEC to invest at least 80 percent of its assets directly in Ginnie Mae securities. (The other 20 percent are invested in other government securities or in Fannie and Freddie securities.)

Historically—and remember that historical performance is just yesterday’s news—GNMA funds have returned about six percent annually before inflation, and their volatility is low compared to other bond funds with comparable yields. GNMA funds offered relatively steady returns right through the housing bust.

Bonds with no default risk? What could possibly go wrong?

A couple of things. First, like all bonds, GNMAs are subject to interest rate risk. If interest rates rise sharply—something bound to happen in the future, since they can’t go any lower than they are now—bonds lose value. GNMA funds have occasionally lost principal in a year like that, although never a lot of principal. Some funds lost on the order of six percent in the early 80s.

You can also get into trouble with GNMAs when interest rates fall. That’s because there are mortgages in them thar bonds, and when rates go down, homeowners refinance. If every mortgage in your bond gets paid off through refinancing, you just made much less on the bond than you expected, plus the fund manager will now have to buy new bonds at lower interest rates. This is called prepayment or call risk.

“It’s what on the street they call convexity,” says Louis Gasper, former executive vice president of Ginnie Mae and now an associate professor in the graduate school of management at University of Dallas. “You tend to get much greater movement in price on GNMAs when interest yields do change.”

Prepayment risk hasn’t been much of an issue in the current low-interest-rate environment, however, because credit has been scarce and because few homeowners want to refinance or prepay while their home value is depressed.

Finally, GNMA funds are actively managed, so you’re counting on the competence of fund manager.

Safe as houses?

So, should you put some money into a GNMA fund?

It’s not a place for high rollers. If “Ginnie Mae” sounds like your grandma’s name, it’s because it would be a good place for her to sock some of her retirement savings. It’s also a good place to find a six percent return when the stock market is going nuts.

In exchange for this fairly steady performance, you give up the chance to earn any returns that could be described as “rollicking.” Indeed, GNMAs tend to underperform during a bullish bond market.

Oh, and if you buy a house today with an FHA or VA loan, as more homebuyers than ever are doing, your loan will end up in a GNMA bond. If you then invest some of your retirement savings in GNMAs, well, you could end up sending your mortgage payments to yourself. Which is not a bad thing. But it is funny.

For more on GNMAs, see this overview from Fidelity.
Disclosure: I don’t own any GNMAs except as a tiny part of a retirement lifecycle fund.

Matthew Amster-Burton, author of the book Hungry Monkey, writes on food and finance from his home in Seattle.