GNMA funds offer safety and fair returns

by Stephen Butler

In the lifetime of a Baby Boomer, the current interest and inflation rates are unprecedented. Making any money on assets we don't want exposed to stock market risk is a major challenge. But then, there are the GNMA funds.

The bonds bought by these funds are issued by the Government National Mortgage Association and have the explicit guarantee of the federal government. This distinguishes them from bonds having only the "implied guarantee" of the other government-sponsored bond programs.

There are 16 GNMA mutual funds, and when the wheels fell off the financial markets, these funds were flooded with new money in what was a "flight to safety." We'll talk about GNMA mutual funds in a moment. For a simple explanation of the concept, however, a bond backed by GNMA mortgages would be bought for $1,000 and would pay interest at the same mortgage rate that we have been reading in the newspaper. As investors, we would collect about $50 per year in interest and get our $1,000 back when we sell the bond.

In real life, things are more complex. In the investors' flight to safety, the actual price of the bonds rose by about 5 percent. As the crisis worsened, investors were willing to pay more than $1,000 - like $1,050 for the bond that would only be redeemed for $1,000. They were effectively giving up the first year of interest they expected to receive because that was a cheap price to pay for the security of an investment guaranteed by the government.

For long term bond-holders (who had bought in originally at $1,000) this rise of 5 percent was great because it was added to the 5 percent of interest that they were scheduled to receive. They got a capital gain of 5 percent in addition to their 5 percent of interest payments.

Someone buying today, however, is buying a bond at $1,050 that is paying interest at a now lower amount as interest rates have dropped. Today's effective yield (or interest rate return as a percent of the amount invested) is down to 3.2 percent. Considering the alternatives, this is still a decent return.

To further complicate matters, the homeowners out there who make payments on the mortgages have an opportunity to refinance when mortgage rates drop. This is what has lowered the interest rates on GNMA mortgages in general, although not everyone can refinance today thanks to the more severe underwriting restrictions. Some people are stuck with yesterday's higher rates. For investors in GNMA bonds, this is a good thing. Older, higher-interest mortgages continue to stay in the investment pool.

If you held these funds for a long time, the loss you can expect to take sooner or later after investing at today's high water mark would average out to be a fraction of a percent per year. Meanwhile, you have a government-guaranteed investment that is cranking out substantially more than any money market funds or bank CD's. You can dismiss any illusions of enjoying total returns of 5 to 7 percent that these funds have demonstrated in recent years. Some of that gain was a response to the behavior of crowds who thought the government wasn't so bad after all - considering the alternatives.

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