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What's Going on With Ginnie Mae (GNMA) Bond Yields?

GNMA bonds are backed by the full faith and credit of the U.S. Government, yet historically yield a premium over equivalent U.S. Treasuries. Until the last few weeks, that seemed to be true. Recently, according to Vanguard's website, the Vanguard GNMA fund (VFIIX) had an SEC yield of 2.52%, while the Vanguard Intermediate Term Treasury (VFITX) was yielding 2.68%. This got me to thinking about pulling GNMAs from my clients' portfolios, but decided to first speak with Thomas Pappas, the manager of this $36 billion fund at Wellington Management, to learn why this premium suddenly looks like a discount.

Why GNMAs pay a higher rate
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.

Why GNMAs historically pay higher yields than Treasuries
I'm not a believer that financial markets are philanthropic, so the extra yield likely comes with extra risk. And the extra risk that the investor takes on with these bonds is the fact that, unlike U.S. Treasuries, the exact timing of cash flows is unknown. That's because, when interest rates go down, people refinance their mortgages and these securities are paid off. Conversely, when rates go up, the refinancing boom grinds to a halt and they are paid off more slowly.

So this pipeline of refinancing when interest rates drop means the GNMA investor will have less upside since people will be paying off those mortgages. But GNMAs have the downside risk if rates increase since the securities will sell at a discount. Thus, the higher yield is compensation for more downside principal risk and less upside potential.

Moneywatch columnist Larry Swedroe is not a fan of GNMAs. He likens them to a Treasury bond with put and call options to try to squeeze out a premium. He states he doesn't see any evidence that call risk has been rewarded anywhere.

Enough background - Why are GNMAs suddenly yielding less now?
I asked a lot of smart people why the yield of GNMAs had fallen below that of U.S. Treasuries, but didn't get an answer until Vanguard set up a call with Thomas Pappas, their portfolio manager at Wellington. Let's just say he gave me quite an education on the subject.

Like Larry Swedroe, Pappas explained that the SEC yield I was looking at was only the accounting view of the coupon payments. It wasn't the total return. Pappas noted the fund was buying what are called TBA (to be announced) securities, which are mortgages in the pipeline that will be completed within 90 days. These are purchased at a discount and the accrued benefit during this period is not reflected in the SEC yield.

Pappas stated that a better way to analyze the yield differences between GNMAs and U.S. Treasuries is to look at the expected yield to maturities. He noted the GNMAs had about a 3.25 to 3.50 percent expected yield to maturity, which is roughly one to one and a half percent above the equivalent U.S. Treasury.

The net-net is that markets aren't stupid, and GNMAs continue to provide a premium yield to compensate for additional downside principal risk. In fact, Pappas stated that the yield premium is right about at its historic average.

Is the yield premium enough to justify the additional risk?
Pappas was quick to point out that anything could happen in the future. He did say, however, that 30 years of history showed the total annual return of the GNMA was roughly 0.50 percent higher than the total return of an equivalent U.S. Treasury. Part of that differential could be the fact that U.S. Treasuries have tax advantages over GNMAs in that the income on U.S. Treasuries is state tax-fee. Though even after taxes, GNMAs still have a total yield premium.

My take
My world has not been turned upside down, and the higher yield on GNMAs is still the case. I have to agree with my colleague, Larry Swedroe, that the higher yield of GNMAs is not free money. I also agree that GNMAs could get hammered in an environment of increasing longer-term interest rates. That said, I probably should disclose that I, along with the nation's top economists, have been forecasting rates directionally incorrect for decades.

Larry and I do not agree, however, on whether GNMAs should be used at all. I am of the opinion that a low cost intermediate-term GNMA fund, like Vanguard's, has a place in many investors' fixed-income portfolio, along with fixed maturity government bonds (including TIPS), Certificates of Deposit, and some very high quality investment grade bonds. That's because GNMAs aren't like U.S. Treasuries with pure puts and calls. There is more that influences the rates of refinancing than interest rate changes alone. For example, increasing interest rates could lead to a recession that could cause more mortgage defaults, which would ironically result in paying off some of this GNMA principal.

Investors should keep in mind that GNMAs are no free lunch. The fact that they have yielded a total return above U.S. Treasuries is no guarantee that they will continue to do so in the next 30 years. Still, I'm going to hold onto mine.


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