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Ginnie Maes' Effect on Portfolios

On Monday, we compared the returns of GNMAs to those of comparable investments in Treasuries. (Neither has any credit risk.) We saw that while GNMAs carry higher yields (which is attractive), higher yields don't necessarily translate into higher returns.

To review, GNMAs carry higher yields because their maturity is uncertain, and the uncertainty always works against you. If rates fall, the expected maturity shortens and reinvestment risk increases. If rates rise, the expected maturity lengthens and price (and inflation) risk increases.

However, looking at asset classes or investments in isolation isn't sufficient; you should look at how their addition impacts the risk and return of your entire portfolio. Looking at things in the whole is the only right way to view things. We can do just that using Morningstar's database, which goes back 20 years.

During this period (1990-2009), the Vanguard GNMA Fund returned 7.0 percent with a standard deviation of 4.6 percent, and five-year Treasuries returned 6.7 percent with a standard deviation of 6.2 percent. We will compare two portfolios that are rebalanced annually:

  • Portfolio A has an allocation of 60 percent to the S&P 500 Index and 40 percent to Vanguard's GNMA fund.
  • Portfolio B has an allocation of 60 percent S&P 500 and 40 percent five-year Treasuries.
It would seem logical to choose Portfolio A, since the GNMA fund produced higher returns with less volatility (during this period at least) than did five-year Treasuries. But, the evidence actually shows otherwise.
  • Portfolio A returned 8.2 percent per year with a standard deviation of 12.2 percent.
  • Portfolio B also returned 8.2 percent but did so with a standard deviation of 11.6 percent.
Thus, while GNMAs were carrying higher yields, their addition didn't result in higher returns, but it did increase portfolio risk. Note that the quarterly correlation of the GNMA fund to the S&P 500 was -0.06, while the correlation of the five-year Treasury to the S&P 500 was -0.28, making the five-year Treasury note a more-effective diversifier of the risks of equities. This example also shows that higher volatility is actually a positive attribute when the correlations are negative.

What is important to note is that this 20-year period was a relatively favorable one for GNMAs. Interest rates were relatively stable, and there was never a spike in inflation that would have caused rates to rise (and maturities to extend) as there was in the 1970s and early 1980s. If data were available going back that far, it seems likely that comparison would have been even worse.

Consider that the standard deviation of the five-year Treasury note was 6.2 percent per year from 1990-2009. However, from 1970-1989, the volatility of the five-year Treasury note was 6.9 percent per year. For the full period 1970-2009, the volatility was 6.6 percent per year. Volatility, in either direction, is bad for investors in GNMAs, as they only earn the risk premium when rates are relatively stable. (Of course, it's possible that the greater volatility was accompanied by higher before the fact risk premiums.)

To summarize, investors in GNMAs have not been rewarded with greater returns, let alone greater risk-adjusted returns. The bottom line is that there are far worse "mistakes" than investing in GNMAs. (It's better to take maturity risk than credit risk, at least you are assured of return of principal.) However, in my opinion there are sufficient reasons to avoid them. In light of the evidence, the risks don't seem worth taking.

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