Who Needs a Mortgage-Backed Securities Fund?

What are GNMA funds good for? Are they suitable for the bond portion of the money you're saving for retirement?

-- Miriam Hill

Miriam,

GNMA funds are a good option for investors who are comfortable with something a little bit riskier than a Treasury bond fund, but less risky than a corporate bond fund. Over the long haul, GNMA and other mortgage-backed securities funds have outperformed Treasury and other government bond funds by an average of two-thirds of a percentage point a year.

However mortgage-backed funds don't act like regular bond funds, and it's harder to understand why they do what they do. Also, while pure Treasury funds pay income that is tax deductible at the state level, GNMA income, like corporate bond income, is fully taxable.

GNMA stands for the Government National Mortgage Association, known as Ginnie Mae. It's the federal agency that buys up mortgage loans from banks and turns them into mortgage-backed securities. As an investor in mortgage-backed securities, you become the mortgage lender. Ginnie Mae adds a guarantee to make timely interest and principal payments, even if the homeowner pays late.

The first thing you should know about mortgage-backed securities funds is that there are three types.

Ginnie Mae funds invest primarily (at least two-thirds) in Ginnie Mae mortgage-backed securities. The balance can be pretty much anything, although many funds restrict themselves to Treasury and federal agency securities.

General mortgage funds invest primarily in mortgage-backed securities with some sort of federal guarantee, a category that includes not only Ginnie Mae securities, but also securities packaged by Fannie Mae (FNM Quote) and Freddie Mac (FRE Quote).

(Note that Fannie and Freddie, along with the Federal Home Loan Bank and the Federal Farm Credit Bank, among others, also issue what's called federal agency debt. These are bonds rather than mortgage-backed securities, and they are a staple of government funds and some Treasury funds.)

Fannie and Freddie mortgage-backed securities are considered slightly riskier than Ginnie Mae's because while Ginnie is a government agency, Fannie and Freddie are private, government-sponsored enterprises. "Congress may be less willing to rescue a financially strapped GSE," University of Missouri professors Charles Corrado and Bradford Jordan write in their forthcoming textbook, Fundamentals of Investments. As with Ginnie Mae funds, the rest of a general mortgage fund can be just about anything.

Finally, there are adjustable-rate mortgage funds, but they haven't really caught on. At the end of August, according to Lipper, there was just $3.5 billion in so-called ARM funds, compared to $41.1 billion in Ginnie Mae funds and $11.6 billion in general mortgage funds.

The key point here is that if you are looking to eke out a bit more yield and return than a Treasury or government fund, but without adding much credit risk, it's important to find out whether a GNMA or general mortgage fund makes a practice of holding anything but federally guaranteed mortgage-backed securities and Treasury securities. Some funds hold private mortgage-backed securities, asset-backed securities and corporate bonds. They can goose a fund's return, but the additional credit risk can also hurt it in an economic downturn.

Prepayment Factor

So why does a mortgage fund, even one whose balance is entirely in Treasury securities, act differently than a regular bond fund? As you know, if you have a mortgage you can prepay it at any time, and are more likely to do so if interest rates fall. Likewise if interest rates rise, you would be less likely to prepay.

Viewed from the perspective of an investor in mortgage-backed securities, that is an option retained by the issuer. As an investor in mortgage-backed securities, you have effectively sold an option in exchange for a higher yield. Your main risk is that interest rates will decline and the rate at which homeowners are prepaying their mortgages will go up, and you will have to reinvest at lower yields. This chart shows how Ginnie Mae and mortgage funds underperformed intermediate Treasury funds during last year's great bull market in bonds.

Mortgages vs. Treasuries Median total return for each mutual fund category, retail funds only
Source: Lipper

But rising interest rates can also hurt the mortgage-backed investor, as they have this year. Mortgage-backed securities are valued based on an assumption about the rate at which homeowners will prepay. It's bad if they prepay more quickly than expected, but it's also bad if they prepay more slowly, since that diminishes the rate of reinvestment.

"Mortgage funds generally do best in periods with relatively stable interest rates," says Casey Colton, manager of (BGNMX Quote)American Century GNMA.

The share prices of mortgage funds normally fluctuate less than those of standard government bond funds, but the dividends fluctuate more as prepayment speeds change, Colton says.

If you are comfortable with these conditions and complexities, then mortgage funds are a suitable investment for your portfolio's bond allocation, particularly if you are uncomfortable with anything that doesn't carry a federal guarantee.

As for the tax issue, if you are choosing between a mortgage fund and a pure Treasury fund, you can figure out whether a mortgage fund's yield is high enough to compensate you for the state tax by multiplying it by 1 minus your state tax rate to calculate the aftertax yield. If you're comparing a mortgage fund to a fund that includes federal agency debt, the agency portion will be taxable at the state level too.

A Note on LETES

Last week's column on CETES and LETES, Mexican and Argentine Treasury bills, could have been clearer on one point.

I wrote that LETES, the Argentine bills, entailed no currency risk because the Argentine peso is pegged to the dollar and most LETES are dollar-denominated. I ought to have spelled out that only a dollar-denominated LETES entails no currency risk. A peso-denominated LETES carries the risk that Argentina will stop pegging its currency to the dollar. That's not considered likely -- Argentina has maintained its dollar peg through thick and thin for years. But it is possible, and accordingly, peso-denominated LETES offer slightly higher interest rates than their dollar-denominated counterparts.

Thanks to the readers who took me to task for this omission.

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