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
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.
Prepayment FactorSo 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
A Note on LETESLast 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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