At Home with GNMAs

11/19/2015 9:00 am EST

Focus: DIVIDEND

Mark Salzinger

Editor and Publisher, The No-Load Fund Investor

GNMA funds with consistent records of good performance are excellent substitutes now for US Treasuries, suggests Mark Salzinger, editor of No-Load Fund Investor.

Most mortgage-backed securities are pools of mortgages whose payments are offered together as a single security. Buyers receive monthly payments that include not only interest but also principal.

Because mortgage borrowers tend to prepay, either by refinancing or selling the property, market prices for mortgage-backed securities are determined at least partly by estimating the rate of prepayments within the pool of loans underlying a specific security.

Prepayment is the risk that the mortgages in a particular pool will be paid off at a faster rate than expected.

Unlike conventional bonds, which tend to rise in price when rates drop, mortgage backed securities become less attractive. This is because prepayment returns principal to investors sooner than expected, thus reducing the assets in bonds paying the older, higher rates.

If investors want to reinvest in similar securities, they have to do so at the lower rates of new securities.

Extension risk is the risk that mortgages will be repaid at a slower rate than expected, which tends to happen when interest rates rise (or home sales slow down). In this case, fewer homeowners will want to refinance or sell.

This effectively extends the maturities of mortgage-backed securities, typically depressing their prices until their yields have increased enough to compensate for the longer maturity.

Because of these risks, mortgage-backed securities must offer investors higher yields than Treasuries from the outset, even though they subject investors to virtually identical credit risk, having the same guarantee from the US Treasury against default.

Vanguard GNMA (VFIIX) recently yielded 2.4%, vs. 1.3% for Vanguard Intermediate-Term Treasury (VFITX).

We think this spread is sufficient compensation for the unique risks of mortgage backed securities is the cure.

Vanguard GNMA’s outstanding record relative to its peers stems from its extremely low expense ratio and its manager’s risk averse approach.

With an expense levy of just 0.21%, manager Michael Barrett doesn’t need to invest in the highest yielding or esoteric mortgage pools to generate an attractive yield.

Instead, Barrett and mortgage analysts at Wellington Management look for GNMA securities that offer attractive yields but with limited prepayment or extension risk.

Barrett can also invest up to 20% of the portfolio in other types of government mortgage-backed securities (such as those from Fannie Mae or Freddie Mac).

Over the past five years, Vanguard GNMA has gained 3.2% on an annualized basis.

The average intermediate-term government bond fund gained only 2.2% annualized over that time, while exposing investors to the same amount of volatility.

We also like Fidelity GNMA (FGMNX). Its managers—Bill Irving since 2004, joined by Franco Castagliuolo since 2009—scour the markets of government mortgage-backed securities for pools of mortgages they believe to be mispriced.

They especially favor securities they believe will prepay more slowly than expected.

Their fund levies a 0.45% expense ratio, which is well below the 0.59% median expense ratio of its peer group. The fund has gained 3.0% a year over the past five years and recently yielded 2.2%.

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