Whenever interest rates are low, investors make mistakes such as reaching for incremental yield. One of the mistakes they make is confusing yield with return. Another is thinking about assets in isolation, instead of how their addition to a portfolio impacts the risk and return of the overall portfolio. Both of these issues are usually factors when investors make the mistake of adding GNMAs to their portfolios, when there are better alternatives.
We discussed this issue back in February, noting that the higher yields offering by GNMAs didn't translate into higher returns and that Treasuries have historically offered better diversification benefits. With the low interest rate environment we're experiencing, I'm still getting questions about whether GNMAs have a place, so here's another take on these instruments.
The good news about GNMAs is that there's no credit risk and they receive a small risk premium for taking interest rate risk. The bad news is that you have no control over the maturity:
- When interest rates fall, mortgagees prepay the mortgage, and the proceeds must now be reinvested at lower rates. (Note the Morningstar estimates that the effective duration of the Vanguard GNMA Fund (VFIIX) is now just 2.6 years, down quite a bit even from earlier this year.)
- When interest rates rise, mortgagees hold on to those mortgages for longer than expected and the duration of the fund rises. Thus, investors get stuck holding bonds with below market rates for longer than expected.
An alternative to the GNMA fund would be the Vanguard Intermediate-Term Treasury Fund (VFITX) -- like the GNMA fund, it entails no credit risk.
The inception date of VFITX was October 28, 1991. Therefore, our analysis covers the period November 1991 through August 2010. While the GNMAs always carry higher yields than similar maturity Treasuries to compensate for the embedded optionality, VFIIX underperformed VFITX, 6.57 percent versus 7.07 percent, illustrating that yield isn't the same as return.
However, as we've stated before, it's how the asset mixes with a portfolio that counts, so let's look at the effect of combining these assets in a 60% stock/40% bond portfolio, rebalanced quarterly. Because we're rebalancing quarterly, the longest time period we can run is from January 1992 through June 2010. We'll stay with Vanguard for this example and use its Vanguard 500 Index Fund (VFINX) for the stock portion:
- The portfolio with the GNMA fund returned 7.31 percent with a standard deviation of 9.5 percent.
- The portfolio with the intermediate-term Treasury fund returned 7.6 percent with a standard deviation of just 9.0 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 the withdrawal phase. 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 note that I don't recommend total bond market funds either. The reason is the presence of mortgage-backed securities (MBS) like GNMAs. The Vanguard Total Bond Market Fund (VBMFX) holds a significant amount of MBS. Currently, it holds about 26 percent, but that figure has been as high as almost 40 percent within the past three years.
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. If you need more return from your portfolio, you should take the risks on the equity side where they have been better rewarded.
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