Why Ginnie Maes May Not Be Right for Your Portfolio

Last Updated Feb 12, 2010 9:13 AM EST

Readers of my books and this blog know I believe you should take portfolio risk through your equity allocation. On the other hand, the role of fixed income is to dampen your overall portfolio risk to an appropriate level. You shouldn't stretch for yield through your fixed income investment, and that includes investing in GNMA (Ginnie Mae) bonds.

Fixed income investments should be limited to Treasuries/government agencies, government-insured CDs and AAA/AA-rated municipal bonds. If you want to take a bit more risk with fixed income in an attempt to increase returns, you should limit credit risk to the short term (three years or less). The evidence shows that's the only place it has been well rewarded. And you should avoid bonds that have "optionality" in them, which means the maturity is not certain.

Two of the common alternatives for seeking higher yields are GNMAs and high-yield bonds. The Only Guide to a Winning Bond Strategy You'll Ever Need goes into detail as to why I don't recommend either. Briefly, there are two main reasons.

  • First, the evidence suggests that while yields are higher than on safer investments, investors haven't been well rewarded for taking those risks.
  • Second, their risks don't mix well with the risks of the other portfolio assets.
My colleague Allan Roth recently ran a column recommending GNMAs, and I commented on his blog, giving my reasons why I would avoid them. That prompted me to check the historical record on returns.

From inception (6/27/80) through 2009, the Vanguard GNMA Fund had an annualized return of 8.34 percent per year. The following are the returns of two indices that might be considered reasonable benchmarks. (The returns are the annualized returns for the time period July 1980 through December 2009.)

  • Gov't Bond Index (1-30 Years) -- 8.40 percent
  • Five-Year Treasury Notes -- 8.53 percent
As you can see, investors in the GNMA fund didn't earn higher returns despite carrying higher yields. And note that you don't have to pay a mutual fund when investing in Treasuries because there's no credit risk to diversify. (Even if you chose to invest in a fund, the costs should be very low.) And for taxable accounts, Treasury investors avoid paying state income taxes. Thus, GNMA investors took greater risks (risks that don't mix well with other portfolio assets) and weren't rewarded.

We now turn to high-yield bonds. From inception (12/27/78) through 2009, the Vanguard High Yield Corporate Fund returned 8.72 percent per year. The following are the returns of two benchmarks. (The returns are the annualized returns for the time period 1979 through 2009.)

  • Gov't Bond Index (1-30 Years) -- 8.45 percent
  • Barclays Capital Credit Bond Index Intermediate -- 8.70 percent
While the Vanguard fund has carried much higher yields than either of these two indices, the fund's realized returns were virtually identical to the returns of the Barclays Capital Credit Bond Index Intermediate (with much less credit risk) and only 0.27 percent higher return than an index with no credit risk. And the risks of high-yield bonds don't mix well with the risks of equities, a lesson investors were reminded of in 2008.

There are two lessons you should take from the above. The first is that you shouldn't confuse yield and return. The second is that you don't need to stray beyond the safest and simplest fixed income investments to achieve your goals. In fact, the evidence suggests you shouldn't.

However, you shouldn't look at investments isolation. On Wednesday, we'll look at how the addition of GNMAs can affect portfolios.

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    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.