Why I Like Ginnie Mae Funds Now

In these unpredictable times, any combination of high safety and fair income should deliver extra value. I continue to extol municipal bonds and investment-grade preferred stock of banks and utilities. But their long durations mean they’re more sensitive to rising rates, and they could fluster you if you’d squawk at the loss of as little as 5% of principal (yield and price move in opposite directions).

This is not an idle thought. The Kiplinger Letter economic team forecasts the 10-year Treasury note, now yielding 1.1%, to yield 2% late this year. That would sink the total return for long-duration fixed-income securities into the red for all of 2021. Now, I can imagine T-note yields hitting 1.5%, but not 2% (we are friendly colleagues here, but we can disagree). That implies you’d break even. But the more bearish outcome is not impossible.

So, what can deliver above-inflation income and still protect your capital in either case? It’s time to re­discover a sometimes overlooked and underappreciated investment: Ginnie Mae (GNMA) funds of government-guaranteed home mortgage pools. These are available at low cost from shops including BlackRock, Fidelity, Pimco, T. Rowe Price and Vanguard, among others.

From just $107.88 $24.99 for Kiplinger Personal Finance

Become a smarter, better informed investor. Subscribe from just $107.88 $24.99, plus get up to 4 Special Issues

CLICK FOR FREE ISSUE

Sign up for Kiplinger’s Free Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

Backed by Uncle Sam. GNMA is the Government National Mortgage Association, which is not an association but a federal agency, so its securities have Uncle Sam’s full faith and credit. That satisfies the safety requirement. The question is whether the income is enough to match or exceed any possible erosion of the principal—a concern if mortgages lose value or higher-rate loans are refinanced in such numbers that these funds fill up with lower-rate debt in a sort of accidental bait and switch. (You thought you were getting 4%, but instead it’s 3%, plus some of the principal back.) When GNMA funds register negative returns, refis (known as “prepayments”) are the usual cause. Managers perform graduate-school math to analyze the optimal interest rate and maturity combination in their funds to soften this threat, but sometimes market forces are just too powerful. In a rough quarter, you can lose 2%.

However, our current lodestar is rising, not falling, rates. That suggests standard bonds such as the 10-year Treasury are in more jeopardy. Yes, if a mortgage this week closes at 4%, wouldn’t that pile of 3% loans also lose value? Logically, yes. But the mortgages as a portfolio should retain their market value better than ordinary bonds if 10-year T-bond yields really do double from 1% to 2%. Moreover, because mortgages have a limited lifespan, whether because a home is sold or the note is prepaid, GNMA securities have a much shorter duration than Treasury, municipal or corporate bonds. A rule of thumb is that for every one-percentage-point rise in rates, you lose principal equal to duration. Currently, the duration on the mortgage component of the Bloomberg Barclays Aggregate Bond index is 2.2, compared with 6.1 for the whole index and 7.1 for the Treasury bond part.

It is okay to think of GNMA funds as substitutes for cash or ultra-short bonds, but GNMA funds’ historical returns are not totally cash-like. Vanguard GNMA (symbol VFIIX) has a five-year annualized return of 3.0%, compared with 1.9% for Vanguard Ultra-Short-Term Bond (VUBFX). The GNMA fund’s trailing 12-month yield is 1.7%, against 1.4% for the ultra-short bond fund. That gap will widen as mortgage rates edge higher while short-term interest rates remain in Federal Reserve lockup.

I mention the Vanguard fund for reference; the other providers’ offerings are much more alike than different. Offering a yield of close to 2% that is trending up, with the possibility of a small capital gain, they are worth exploring.