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Two Ginnie Mae Funds for Good, Safe Income

By Philip Springer on September 21, 2011

Among the many challenges investors face these days is how to generate decent income at low risk. After all, cash equivalents, such as money-market funds, pay virtually nothing. And U.S. Treasury securities aren’t much better, with the yield even on issues that mature in 10 years hovering around 1.9 percent. That’s a negative return after inflation and taxes.    

One of the best solutions is no-load mutual funds that invest in Government National Mortgage Association (GNMA) mortgage securities. Ginnie Mae securities are explicitly backed by the U.S. government. This means they carry the lowest credit risk of just about any investment, despite Standard & Poor’s questionable recent downgrade of U.S. debt from AAA to AA.

Like other fixed-income vehicles, Ginnie Mae securities increase in value when interest rates decline. Therefore, the biggest risk is that prices drop when interest rates rise. Yet Ginnie Maes historically have reacted somewhat differently than plain-vanilla Treasury issues to interest-rate swings.

When rates fall, a U.S. Treasury bond continues to pay interest at the same pace as before. But falling rates typically encourage homeowners to pay off their mortgages, either by refinancing to new, lower-rate loans or selling their homes and moving into new ones. Either way, investors in the original mortgages end up with more cash, thereby reducing the benefit of falling rates. Conversely, when rates go up, mortgage securities can lose more value than Treasurys. Reason: Home refinancings and sales slow, reducing investors’ interest payments.

But three positive factors more than offset this drawback. First, GNMAs carry higher yields than Treasury issues of comparable maturities. This yield advantage typically runs to 1-1.5 percentage points. Over the last 30 years, the total return (yield and price change) of GNMAs has been about 0.5 percent higher than those of equivalent Treasury issues, according to investment firm Wellington Management. Because of the sharp interest-rate decline since 2007, Treasury issues have outpaced GNMAs of late. But that’s unlikely to continue in light of today’s historically depressed rates.

Second, the Federal Reserve has said it will keep short-term rates near zero until at least 2013 amid a sluggish economy. Reduced interest-rate risk is a plus for vehicles carrying higher yields, as well as nominal credit risk in a lackluster economy.

What’s more, the new supply of mortgage securities has been limited in recent years. One reason is that home-purchase activity has been depressed. And the weak housing market means that many borrowers don’t have enough home equity to refinance. Plus, credit is less easily available. In the long run, this positive supply-demand dynamic is in sharp contrast with the Treasury situation, in which soaring deficits mean much more bond issuance.

Among no-load GNMA mutuals, two stand out. Vanguard GNMA (VFIIX) is the largest Ginnie Mae fund, with $36 billion in assets. At least 80 percent of the fund is invested in Ginnie Mae securities. Most of the rest is in other agency-backed securities, including those of Fannie Mae and Freddie Mac, which have implicit U.S. backing.

Vanguard GNMA carries a current yield of 3.1 percent. Aided by a rock-bottom expense ratio of 0.23 percent, the fund has delivered a 7.3 percent total return in the last 12 months, with average annual returns of 7.4 percent over three years, 7 percent in five and 5.7 percent for 10. The fund ranks in its category’s top quintile over each time period.

Fidelity GNMA (FGMNX), like the Vanguard fund, largely sticks to the basics of GNMAs and federal agency vehicles with low credit risk. Current yield: 3.1 percent. Within this market, the two managers aim to minimize prepayment risk as rates decline. So, despite a higher 0.45 percent expense ratio, the $8.5 billion fund has slightly outperformed its Vanguard counterpart, with returns of 7.3 percent, 8 percent, 7.3 percent and 5.7 percent respectively.

The investment environment for government-backed mortgages won’t stay this favorable forever. But both funds have a superior long-term record of adapting to changing markets and delivering reliable, low-risk income.

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