Ginnie Mae funds need a review as rates slide Wave of refinancing can cut into yields


If you have invested in a GNMA fund to earn good income, you may be wondering whether to switch to another kind of taxable bond fund before yours feels the full impact of the recent decline in interest rates.

If, on the other hand, you've been planning to invest in a GNMA fund, you may be having second thoughts about making such a move at this point in the bond market cycle.

In either case, your concerns would be understandable. But what do you do about them?

First, consider the unusual risk and reward characteristics of the securities that GNMA funds hold. And think about their possible short-run behavior in a longer-run perspective.

Then, if you find that such a fund would be suitable for part of your portfolio, study your fund -- or the one you're considering -- to be sure its policies and riskiness are compatible with your investment goals.

Such funds invest at least 65 percent of their assets in "Ginnie Maes," mortgage-backed securities whose timely interest and principal payments are guaranteed by the Government National Mortgage Association (GNMA).

The GNMA guarantee, equivalent to the government support behind U.S. Treasury securities, endows the agency's securities with the highest credit quality.

But it does not eliminate two risks, which fund brochures and brokers' sales pitches may not give equal prominence:

* Interest rate risk -- the risk that the price of a fixed-income security will fall when interest rates rise.

* Prepayment risk -- the risk that, when interest rates fall, homeowners prepay their mortgages faster than normal, usually refinancing to reduce monthly payments.

At such times, GNMA funds must replace securities in their portfolios with lower-yielding issues, reducing their income.

Interest rate risk is difficult to deal with -- by adjusting a portfolio's maturities, for example -- because no one can predict rates accurately.

Prepayment risk is even tougher to manage. It depends on the individual responses to rate changes by thousands of homeowners, and that may be difficult to predict.

Fund managers coped with two periods of surging prepayments in 1992 "with reasonable" success, says Jack Lemein, manager of the $14 billion Franklin U.S. Government Securities Fund, the largest.

They expect another wave soon -- the third in 13 months -- to reflect the recent trend that has left yields at the lowest levels in 20 years.

To compensate investors for accepting prepayment risk, Ginnie Maes provide higher yields than Treasury issues of comparable maturities. (Owing to prepayments, the expected life of an average 30-year Ginnie Mae may be only 10 years of less.)

So, Ginnie Maes have produced moderately higher total returns, over time -- even though Treasuries outperform Ginnie Maes when rates fall (and when one can't use Ginnie Maes to "lock in" yields).

A well-managed GNMA fund should enable you to benefit from such performance, provided that you make it a long-run investment. If you'll need your money back in a year or so, you may wish to consider starting to redeem your shares, or not investing in the first place.

Top-performing GNMA funds have a variety of strategies, both in terms of the percentage of Ginnie Mae holdings and the ways in which they balance concerns over prepayment risk with the desire to pay dividends at high rates.

Funds of Vanguard, Smith Barney, Princor, Benham, Lexington, Franklin, Fidelity and Scudder tend to be more than 90 percent invested in Ginnie Maes.

Others also hold U.S. Treasuries or other securities in varying degrees, leading to results that may be better -- or worse.

Managers such as Paul G. Sullivan of the Vanguard GNMA fund, Princor's Martin Schafer, Benham's Randall Merk and Scudder's David M. Glen have tried to reduce their vulnerability to &r; prepayments by investing in lower-coupon Ginnie Maes that they felt less likely to be prepaid.

Outstanding Ginnie Maes have coupons ranging from around 7 to 15 percent, but the weighted average coupon of all outstanding 30-year issues is around 9 percent, according to Salomon Bros.

Sullivan, who had been below the average, recently raised his portfolio to 9 percent -- despite the higher prepayment risk -- because he believes we're approaching a cyclical low in interest rates and he wants to be more defensive.

Coupons, of course, aren't managers' only focus. Merk and Glen, for example, also look at the age of Ginnie Mae pools.

They prefer new ones, on the assumption that the homeowners behind them won't have the cash to prepay, and older ones, on the assumption that -- for some reason -- the people behind those didn't seize earlier opportunities to prepay and may not do so now. They avoid those from 2 to 5 years old.


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