GNMAs: You Can Do Better

Whenever interest rates are low, many investors stretch for incremental yield in hopes of earning higher returns from their fixed income investments. Among their bond choices are GNMAs, which have higher yields than comparable Treasuries while still not having credit risk. Unfortunately, there are two reasons why going with GNMAs is a mistake.

We'll use Vanguard's funds to illustrate. As of August 19, Morningstar showed the Vanguard GNMA Fund (VFIIX) having a yield of 3.2 percent, 1 percent higher than the 2.2 percent yield of the Vanguard Intermediate-Term Treasury Fund (VFITX). VFIIX has an expected maturity of 5.3 years, almost identical to the 5.5 maturity of VFITX. However, this leads us to the first mistake investors make: confusing yield and return.

While the GNMA fund will always have a higher yield than the similar Treasury fund, that doesn't mean its return will be higher. In fact, for the past five years ending August 19, VFITX outperformed VFIIX 7.9 percent versus 7.1 percent, and in the past 10-year period it outperformed 6.3 percent versus 5.9 percent. In addition, over the 12 months ending August 19, VFITX outperformed VFIIX 8.5 percent versus 6.5 percent. This is a time when the stability of fixed income was especially valuable, given that the Vanguard 500 Index Fund (VFINX) lost 8.2 percent.

You should also consider what happened in 2008, when investors needed their fixed income assets to offset the massive drop in equities. With the S&P 500 Index losing 37 percent, VFITX outperformed VFIIX 13.3 percent versus 7.2 percent. Clearly higher yields don't always result in higher returns.

Now it's important to recognize that there are periods when GNMAs will outperform similar Treasuries. For example, in 2009 VFIIX outperformed VFITX 5.3 percent to -1.7 percent. But the outperformance came during a period that was good for equities, when it was less important, especially for those in the withdrawal phase of their investment cycle.

The second mistake investors make involves one we've discussed before regarding a wide range of investments: viewing the performance of an investment in isolation. Instead, they should consider how the addition of an asset impacts the risk and return of the entire portfolio.

The following example is an updated version of the example from the last time we discussed why GNMAs shouldn't be your bond choice. Let's look at the effect of combining either VFIIX or VFITX with VFINX in a 60 percent stock/40 percent bond portfolio, rebalanced quarterly. (Because we're rebalancing quarterly, the longest time period we can run is from January 1992 through June 2011. And remember that past performance is no guarantee of future results.)

The portfolio with the GNMA fund returned 7.8 percent with a standard deviation of 9.6 percent.
The portfolio with the intermediate-term Treasury fund returned 8.1 percent with a standard deviation of just 9.1 percent.

The portfolio with the lower-yielding Treasuries produced both higher returns and a lower level of volatility. And this was during a period that generally favored GNMAs, because interest rates were fairly stable, and we didn't experience a period of high inflation and rising rates like we did in the 1970s.

The following are some other interesting points:

Over the full period of almost 20 years, VFIIX underperformed VFITX (6.4 percent versus 6.7 percent) despite the persistently higher yields.
VFIIX also exhibited a lower level of volatility. Its annual standard deviation was 3.2 percent versus 5.8 percent for VFITX.
Despite its lower volatility, VFIIX produced a more volatile portfolio than VFITX, 9.6 percent versus 9.1 percent.

It's also important to note that the portfolio with GNMAs experienced larger losses in the worst periods. This is particularly important for those in retirement drawing down their portfolio. For example, the portfolio with GNMAs lost 19.3 percent in 2008, 2.4 percent worse than the 16.9 percent loss experienced by the portfolio with intermediate Treasuries. For 2002, the figures are losses of 9.4 percent for the portfolio with GNMAs versus a loss of 7.6 percent for the portfolio with intermediate Treasuries. This demonstrates that the risks of GNMAs don't mix as well with the risks of equities as do the risks of Treasuries.

Before concluding, it's important to make sure that you fully understand the nature of the risks of GNMAs (or any investment, for that matter). For GNMAs, their expected duration shorten at the wrong time -- when interest rates fall -- because borrowers prepay or refinance to lower rates earlier than expected. Also, the expected duration will also rise at the wrong time -- when interest rates rise -- because borrowers will stay in their homes longer than expected, not wanted to give up that mortgage which now has a rate below the current market rate. This can become a real problem if we have a repeat of the 1970s.

Investors in GNMAs could be stuck with very low yielding assets for a much longer period of time than they expected. And it also might come at a time when stocks do poorly - an investor hell if there ever was one.

More on MoneyWatch:
Why GNMAs Shouldn't Be Your Bond Choice Why Ginnie Maes May Not Be Right for Your Portfolio Ginnie Maes' Effect on Portfolios Market Volatility: European Banking Fears Cause Market to Drop This Time, It Actually Is Different
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Larry Swedroe

Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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