Last Updated Dec 12, 2010 11:25 PM EST
GNMAs are mortgage backed securities that are packaged and guaranteed by the Government National Mortgage Association. Unlike Fannie Mae and Freddie Mac, the Ginnie Mae has always been a government entity, with essentially no default risk.
Recently, yields were as follows on the following intermediate bond funds.
- 1.61% - Vanguard Intermediate Term Treasury (VFITX)
- 2.58% - Vanguard Total Bond Index (VBMFX)
- 3.20% - Vanguard GNMA (VFIJX)
With the GNMA bond yielding twice the Treasury bond, it might appear that the GNMA is superior. And when you consider the average duration (a measure of interest rate risk) of the GNMA bond is 1.9 years while the Treasury is 5.3 years, GNMAs look especially attractive. But as I've noted before, there is no free lunch here.
GNMA durations are estimates only because the payoff dates of the underlying mortgages are uncertain, rather than being fixed as is the case with many other bonds. When people refinance or have their houses foreclosed upon, the mortgages get paid off early. Thus, the actual durations can vary greatly from the estimates. Increasing rates might stop the refinance wagon, but could also actually speed up the repayments if it causes an increase in foreclosures.
Is the higher yield worth the risk?
My colleague, Larry Swedroe, correctly observes that the total return is more important than the yield. According to Wellington Management, the manager of the GNMA bond fund, the GNMA has yielded an extra 0.5% over the equivalent duration Treasury bonds. This extra yield is compensation for two factors:
- Less upside potential from GNMAs when interest rates decline, as people will refinance their mortgages.
- Treasuries are State tax-deductable while GNMAs are not. Thus, some of the extra GNMA yield is taken by taxes.
I do have to disagree with Larry Swedroe's analysis that GNMAs haven't given extra yield. Markets are generally efficient and avoiding GNMAs is yet another misguided attempt to be smarter than the market. I own and recommend GNMAs, as I do Treasuries and corporate investment grade bond funds. The Vanguard Total Bond Fund owns all of these with dirt low costs and high liquidity.
My take on fixed income - even better than bonds
While I do own all investment grade securities, I prefer the free lunch of certain certificates of deposits (CDs). The potential of a bond bubble is real and all intermediate bonds and bond funds will get hit pretty hard when interest rates rise. Certain CDs give higher yields than even GNMAs, yet provide downside protection from higher rates. In my opinion, they are better than bonds.
These CDs are best bought directly from the institution, which cuts out all advisors who charge either commissions or assets under management. That's precisely why they do exist.
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