Could Ginnie Mae Funds Fall Out of Favor?
Ginnie Mae funds have long been a popular choice for investors, and that continues to be the case. The six largest mutual funds focusing on Ginnie Maes hold over $37 billion in assets. However, some advisors’ commitment to Ginnie Mae may be waning.
“I used to recommend Ginnie Mae funds, but I’m not buying them now,” says Don Martin, a CFP and president and founder of Mayflower Capital, an investment advisory and financial planning firm in Los Alamos, Calif.
Why Martin’s disenchantment? He, and others, point to their performance during periods of interest rate changes.
NOT AS DEPICTED IN ‘THE BIG SHORT’
The Government National Mortgage Agency guarantees the payment of principal and interest on mortgage loans issued by federal entities such as the Federal Housing Authority and the Department of Veterans Affairs. The loans are packaged into securities backed by that debt, and then offered to investors.
Ginnie Mae mortgage bonds, known as pass-through securities, have full-faith-and-credit support from the U.S. government. “These are not the mortgage-backed securities that were in “The Big Short,” says Hugh Smith, a CFP who is co-owner and CIO of the Welch Group, a wealth management firm in Birmingham, Ala., referencing the book and film about the 2008 financial crisis.
Investors can buy Ginnie Mae bonds directly, and many do. “We’ve owned Ginnie Maes in the past,” says Smith. “However, just as homeowners pay a combination of interest and principal each month, investors get some return of principal along with the monthly interest income.”
Especially for investors who use the monthly income for spendable cash, reinvesting small amounts of returned principal can be a problem — but failure to do so can lead to principal erosion.
“That’s one of the advantages of investing in Ginnie Maes through a fund,” says Smith. “Funds typically pay out the interest and reinvest the returns of principal in more Ginnie Maes.”
SAFETY PLUS YIELD
Thus, Ginnie Mae mutual funds can appeal to investors. “They check all the boxes,” says Sarah Bush, a director for fixed income strategies at Morningstar, adding that funds have been suitable for basic fixed-income allocations.
“They’re not risk-free, but there is an implied lower risk with these investments because Ginnie Mae funds are the only mortgage-backed securities that are insured by the federal government,” says Cathy Pareto, a CFP who is president of Cathy Pareto & Associates, a financial planning and investment management firm in Coral Gables, Fla. “If the actual mortgage borrowers fall behind on their payments, investors are still guaranteed to get their income from the bond fund” because of Ginnie Mae’s obligation.
“Ginnie Maes have a high degree of liquidity,” Pareto adds, enumerating other advantages. “In addition, they offer higher yields than U.S. Treasuries.”
Recently, Morningstar was showing the 30-day SEC yields of the four largest Ginnie Mae mutual funds at 2.1%-2.6%; the yields on five- and 10-year Treasuries (before any haircut for fund fees) were 1.5% and 2.0%, respectively.
The higher yields of Ginnie Maes versus Treasury yields reflect the nature of mortgage-backed securities. Like most bonds, they tend to lose value when interest rates rise — and the specter of rising yields is on the minds of investors these days.
“With Ginnie Mae funds,” says Pareto, “income is guaranteed, but the underlying value of the pooled mortgages will fluctuate. If interest rates rise, they could suffer a dramatic fall, depending on their duration.”
Moreover, mortgage-backed securities face an additional pitfall when rates rise. “Currently, the most relevant risk with Ginnie Maes is extension risk,” says D.J. Shaughnessy, vice president and portfolio manager with Wellesley, Mass.-based F.L. Putnam Investment Management. When interest rates rise, fewer homeowners refinance their mortgages, so the loans stay in force longer than had been projected.
A slowdown in refinancing will lengthen the duration of Ginnie Maes in a fund, reducing their ability to reinvest incoming cash at then-higher interest rates. Shareholders will be holding longer-maturity issues, increasing the fund’s exposure to interest rate moves.
“In the short term,” says Shaughnessy, “this could result in downward price pressure on Ginnie Maes. It’s possible that interest rates will rise quickly and investors will be stuck with Ginnie Maes that pay relatively low yields because they are tied to mortgages that were initiated or refinanced at extremely low interest rates.”
Bush points to a “blip” that occurred in mid-2013, when specialized Ginnie Mae funds had “huge outflows.”
At this time, interest rates moved up and investors were surprised by weakness in Ginnie Maes after a long period of reliable returns. From early May to early July of that year, Bush points out, Ginnie Mae funds lost from 5% to more than 6%, and outflows increased.
In addition, falling interest rates can be a mixed blessing for Ginnie Maes. When mortgage rates drop, more homeowners refinance their loans, so prepayments speed up. Consequently, Ginnie Mae funds must reinvest in a lower-yield environment.
Mayflower Capital’s Martin is particularly concerned about the risk of loss of principal due to prepayment if mortgage-backed bonds were acquired when they were trading over par, as has been common during the recent years of low yields.
“Suppose an investor buys a bond for 110 points and it gets refinanced at 100 points,” he says. “Then the investor loses.”
Given the pros and cons, are advisors courting Ginnie Mae now?
“We have allocated 10%-20% of clients’ bond portfolios to Ginnie Mae funds,” says Shaughnessy. “Most of our private clients are older, retired and drawing income from a balanced portfolio. These clients understand and appreciate the relative safety of Treasury bonds, but they also understand that Treasury yields are underwhelming.”
Thus, the higher yields of Ginnie Maes can be appealing.
Shaughnessy prefers to hold Ginnie Maes in low-cost mutual funds. “Cost is always an important factor,” he says, “but perhaps underestimated in this space is the value of active management. Analyzing the structure and credit quality of the bonds, building a diversified portfolio and managing the overall duration of the fund are important functions.”
As an example, Shaughnessy points out that the Vanguard GNMA fund is sub-advised by Wellington Management, a highly regarded manager of institutional portfolios that is available to individual investors only through such a sub-advisory relationship.
What about the high-low risks of interest rate movement?
“If interest rates rise slowly or remain level, Ginnie Maes should hold up well and be a relatively safe place to allocate a portion of the portfolio,” says Shaughnessy. “We believe a gradual climb in rates over a period of several years is the most likely scenario. Also, with housing turnover starting to move higher, the flow of new mortgages available at prevailing rates will increase and help mitigate the price pressure should interest rates rise.”
Similar attachment to Ginnie Mae is voiced by Smith. “We have a tactical safety net approach for retirees and pre-retirees,” he says. “That generally means holding 40% of the portfolio in fixed income, with 25% of that allocation — 10% of the overall portfolio — to Ginnie Mae funds. Our younger clients are mainly in stocks, but some conservative ones also hold Ginnie Maes.”
Smith notes that retired clients depending on investment cash flow like the fact that Ginnie Maes pay monthly interest. “For that purpose,” he says, “the monthly draws are ideal. We’ve been using Ginnie Mae funds for years, and no client has ever complained about them.”
Pareto’s clients also have some allocations to Ginnie Mae. “Some hold them directly in a Ginnie Mae fund,” she says. “Others own them indirectly in a fund that has a portion of its assets in Ginnie Mae strategies. Usually, Ginnie Maes are held in IRAs.”
Unlike Treasuries, which generate interest that avoids state and local income tax, Ginnie Maes pay fully taxable interest, so these funds may be better-suited to a tax-deferred retirement account.
Meanwhile, Martin has broken up with Ginnie Mae, at least for now. “The reason to own Ginnie Maes,” he says, “would be an anticipated risk of loss due to borrower defaults. I doubt this will happen, because loan underwriting since 2009 has tightened up a lot, and many areas of the country don’t have bubbly house prices.”
Currently, Martin’s portfolio is focused on Fannie Mae and Freddie Mac mortgages, “opportunistic” defaulted debt, municipals in investment grade states and short-term corporate investment grade bonds. “Fannie and Freddie loans have higher yields than Ginnie Maes, so I don’t buy Ginnie Maes,” he says.
Mortgage-backed securities from Fannie and Freddie also have duration risk, but Martin addresses that risk by focusing on short-duration holdings. Prepayment risk among these agency issues should be the same, he says.
“The key to dealing with prepayment risk is to assemble a portfolio that avoids bonds worth more than par,” Martin adds, “so I buy mutual funds where the manager exhibits a desire to deal with this problem, which is demonstrated by a portfolio with an average price close to par.”
Weighing prepayment and extension risks may be vital for planners constructing portfolios, but challenging to explain to clients. If advisors decide the potential payout is worth taking those risks, a simple message may make the case. Bush points out that Ginnie Maes held up well during the 2008 crash, as funds posted positive returns.
“Ginnie Maes do their job when the equity markets head south,” she says, an attribute that might hit home for safety-minded investors.