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GNMAs in a QE3 World

11/30/2012 7:45 am EST

Focus: FUNDS

Jim Lowell

Senior Partner & Chief Investment Strategist, Adviser Investments

Mortgage-backed securities have not been a 'go-to' spot for investors recently, but that may be changing, notes Jim Lowell of Forbes ETF Advisor.

SUBJECT: Are GNMA funds most likely to benefit from the buying of mortgage-backed securities in QE3?

JIM: In short, yes. But I want to give a longer answer. With yields on most bond boughs looking more like shrunken heads than nourishing fruit, many investors are reaching out along the riskiest bands of the bond spectrum to offset the low-yield toll on their income.

Chasing yield is always most tempting when one has basically no business doing so. With money market yields at zero and short-term Treasuries yielding less and less, a GNMA ETF can both increase your yield advantage over those two safe haven options, while also maintaining the risk-reduced quality of what you own.

While we don’t list any GNMA ETFs, we do track the iShares Barclays GNMA Bond Fund (GNMA), which began trading in February.

GNMAs are the only mortgage bonds that are backed by the full faith and credit of the US Government via the Government National Mortgage Association. These bonds are created by packaging hundreds or thousands of home mortgages with similar characteristics into a single security. The interest and principal payments of all the individual loans are passed through to the bondholder.

I know that a common concern about GNMAs—and mortgage-backed-securities in general—is the risk that as interest rates fall, the bonds are paid off ahead of schedule (through refinancing), and the bondholder is forced to reinvest at lower interest rates.

This prepayment risk is a legitimate concern, but one that is mitigated by the current landscape where banks are not as willing to lend, though mortgage rates may be at or near their historic lows.

If you are interested in having a part of your bond portfolio be in the GNMA sector, we do track several ETFs that invest “momentum risk.” Many investors have been chasing yield by investing in high-yield funds. The momentum risk comes when they all decide to chase something else, a low probability in the current environment.

But the risk I remain most focused on is the interest rate risk that attends the “safest” types of bond fund investments into which investors have been pumping money from their stock funds. While there was a time (2008-2009) when such pumping would have helped save a sinking ship, the flood of money into “safe” bond funds threatens to sink that ship when (not if) interest rates rise.

A mere 1% rise in interest rates could see a loss of more than 15% for longer-term Treasury ETFs. That same rise could see an 8% to 10% toll on more diversified ETFs.

So, there will come a time when having to defend against interest rate risk makes more sense than having to defend in GNMAs: iShares Barclays MBS Bond (MBB), iShares Core Total US Bond Market (AGG), SPDR Barclays Aggregate Bond (LAG), and Vanguard Total Bond Market (BND). AGG has been a longstanding member of our Growth & Income model portfolio.

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