First, it's important to point out that GNMAs carry the full faith and credit of the U.S. government, and they carry higher yields than similar maturity Treasury bonds. In addition, I would generally prefer to see investors take term risk than credit risk. At least with term risk, you'll get return of principal, if not return on principal (in real terms). But with credit risk you aren't assured of anything.
Second, the problem with GNMAs is that buyers don't know the maturity of the investment. We can only estimate the maturity. The ultimate maturity is based on actual prepayment. When rates fall, borrowers tend to prepay sooner, investors get their principal back early, and reinvestment risk shows up because rates are now lower. When rates rise, borrowers slow down their prepayments, not wanting to give up their now below-market mortgage. This causes extension risk to show up, with investors now stuck holding below-market rates assets for longer than expected.
Third, the above risks of GNMAs result in them being less effective diversifiers of equity risk as other bonds with similar maturity and credit risks.
Fourth, one of the most important principles of prudent investing is that you shouldn't invest in any security unless you fully understand the risks. And you can be sure most investors don't understand the issues of negative convexity that are a feature of GNMAs. If you can't explain what negative convexity is, you shouldn't buy GNMAs. Yet, despite the above logic and the historical evidence, GNMAs are among the most popular fixed income investments. The Vanguard GNMA Fund (VFIIX) had more than $35 billion in assets as of August 2011.
With that in mind I thought I would try one more experiment that at least might help you better understand what you're getting when you buy GNMAs. Consider the following. You have two choices for the equity portion of your portfolio.
- An S&P 500 Index fund
- An "enhanced" S&P 500 Index fund that writes both puts and calls on the index to generate the enhancement in the form of the premiums collected. In return for the put and call premiums, you give up the gains above the call price and increase your risks if the index falls below the put price.
- An intermediate Treasury bond fund with an average maturity of five years.
- An intermediate Treasury bond fund with an average of five years that writes puts and calls to take in the premiums. In return for the premiums, you give up the benefits of rates falling to the point that prices rise above the call price, and you increase your risks if rates rise above the level that would cause the price to fall below the put price.
I believe the reason that most individuals invest in GNMAs is they're tricked just like Snow White was by the wicked witch. They focus on the higher yield (the shiny apple) and don't see the risk (poison) inside.
Photo courtesy of taxbrackets.org
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