I've been playing around a bit more with Vanguard's Ginnie Mae Fund, which Bruce has liked, above I believe a $10 NAV, as we continue to see Mortgage Securities hyped, and in conjunction with an analysis that Mortage Bond refinancing has been the major contributing factor to a disappointing capital return component on the Total Bond Market Index.Mortgage Securities, mostly government backed, are about 40% of the Total Bond Market Index. They are not in any of the maturity specific indices (short, intermediate, long), I guess because they are too immature to qualify for any maturity (or classified as unclassified, as to maturity, kind of like fraternity boys).I think historically, Ginnie Maes have been treated pretty much as a gimmie—you could get about 1% on the average higher yield than Treasuries for essentially the same default risk. Mortgages were taken out for 30 years by solid middle class citizens, who stayed put and rarely refinanced, and the extent to which they did, it was priced into the bonds (which was part of the premium).The world has changed. If you look at the yield premium on Vanguard's GNMA fund compared to the Intermediate Treasury fund, over the last 10 and 5 year periods, it is only about .4%. And the capital return on the GNMA over 10 years(through December 2005) is slightly negative and over 5 years just slightly positive, despite significantly lower yields at the end. This capital return leakage, as I've been calling it (sometimes) is probably from refinancing that has been far more common with deeper interest rate drops that could have been priced in at the beginning of these periods. I would assume the lower yield differential can be attributed to ARMs substituting for 30-year mortgages.So, I think we have to conclue that a GNMA fund will see a loss on capital return when interest rates go up (and people don't refinance), but the flip-side of a capital gain from declining interest rates will be limited by refinancing. Heads I lose, tails I don't win as much as I lost on heads.But what about individual Ginnie Mae packages ($25,000 minimums). Presumably, with financing risk, you never buy at a premium (or at least hardly never). What about at a discount or par? Should these be seen as legitimate AAA bonds and evaluated accordingly (i.e., in comparision with other AAA bonds, tax consequences, commissions)?
First, there are two ways to get GNMAs. One is primary market and the other is secondary. Primary market, you give your broker an order and buy at auction. A GNMA is usually $25000 face, and you don't pay a premium. That's what you tell your broker. Secondary market, a large broker, probably one of the wirehouses, has an inventory of pieces of GNMAs. Remember that return of principal starts, although slowly, with the first monthly payment. In a world of rising interest rates, it has been difficult in recent years to get one without paying a premium. But I am entirely bull-headed in this matter, with the result that I haven't bought any GNMAs recently. At the time of the S&L crisis there were a lot of these available from distressed S&Ls. Now they are much less common, but it is worth asking. You might latch onto a piece that is 15 years old, has had a number of prepayments and has just $5000 or so principal left, and maybe at 99.5 or so. Again, don't pay a premium. These are like a bond callable at par any time. Another twist is the CMO--Collateralized Mortgage Obligation. These come in $1000 denominations. A bank or mortgage company buys a bunch of GNMAs (or Freddie Macs, or Fannie Maes) and repackages them, sells "tranches". Somebody can buy all the initial principal payments while everybody else gets interest only for awhile. When that first owner has received back all his principal, the payments go to the next tranche. The retail customer usually gets no principal until everyone else has been paid off, so you may get a stable interest-only payment for the first several years of the investment, and you probably won't be fully paid off for the 30 years of the original mortgages. The bank that does this repackaging will take about 1/2% of interest for the trouble, plus a little extra float--you get paid on the 25th instead of the 15th. CMOs sell at a discount more commonly than do GNMAs. You have another intermediary in there, but the US government guarantees GNMAs as to timely payment of interest and principal, so there shouldn't be a default problem and I've never heard of one. A GNMA, or a CMO, does have a final maturity date. Unlike a bond, there is no big lump sum at the end of the investment, and if you've frittered away your principal that comes to you in dribbles over the life of the investment, tough. Actually I've had CMOs pay interest only for several years, then pay off completely over a 3-month period. Of course, this occurs when interest rates are down, home owners can refinance to their advantage, and you can't find another equally good use for your money. Like bonds being called, it will always happen at the most inconvenient time. For an aging retiree looking for income, the GNMA or the CMO may be a good idea. That person may not need to worry about reinvesting and may consider the return of principal a part of their withdrawal rate. Best wishes, Chris
So would you say that a Fidelity or Vanguard Ginnie Mae fund is inadvisable, and total bond market index funds, or a mix of short, medium and long bond index funds, would be better? I don't have the time or will to search for individual bonds, but need to have significant bond exposure for asset allocation purposes.
But what about individual Ginnie Mae packages ($25,000 minimums). Presumably, with financing risk, you never buy at a premium (or at least hardly never). What about at a discount or par? Should these be seen as legitimate AAA bonds and evaluated accordingly (i.e., in comparision with other AAA bonds, tax consequences, commissions)?Yes AAA or better, they are more secure then Fannie's and Freddie's which are often sited as AAA. I guess because they are too immature to qualify for any maturity (or classified as unclassified, as to maturity, kind of like fraternity boys).Its the continous call provision that makes them maturity funky for fund purposes. 7-10 years is the average life expetancy of most mortgages. We are in a era where I believe things are much shorter. Folks that refinanced to an ARM to capture low rates are now going to chase a new rate and a more traditional 15 or 30 year mortgage. Total cost savings after fees and appraisals???? jack
I don't buy bond funds. Period. They never mature. I am prejudiced, old and opinionated, and will not hear of bond funds. MAYBE if I REALLY wanted bonds issued by an emerging market company and couldn't buy them individually a fund might make sense. But US corporates, or, worse, government bonds--fuhgetit. Treasuries by definition have no risk. Why pay a fund manager? Use Treasury Direct and buy 'em at auction. No trading costs. Zero. I have an account with a good broker at Merrill. When I want to invest in another bond, I call her up and give her my parameters, which she knows anyway: investment quality, no premium bonds. Mature in whatever year fits my ladder at the time. Callable OK, but let me know the details. She'll give me 2 or 3 to pick from and I'll make a choice. If I buy "from inventory" all costs are in the spread, and if she quotes it at 99 that's what it will cost. What could I immediately sell it for? Don't know, don't care. Tell me the yield to maturity and if there is one, yield to worst call. If I'm getting paid 6% through 2025, that's what I want to know and compare. It does NOT cost more to buy bonds through a full-service broker than to get them from a discounter. You own a bond. You do not trade it. Now Charlie (imdajunkman) is a different story, he trades, and very successfully. He works at it very diligently. I've owned bonds for 46 years now and never once sold one. They mature or get called away. Never had a default, came close once. Stocks are a different matter. I trade those with a deep discounter and do my own picking. If my broker suggests a bond issued by a company I never heard of, either I pick a different bond or do some research on the company. If you start with good quality you do not have to diversify your bonds. Just pick something that isn't going to default. Treasuries are a good start, corporates pay better, munis if you are in a high tax bracket. Nothing that difficult about the whole thing, IMNSHO. Best wishes, Chris
Crosen:With all due respect, I think that if you are going to buy into GNMAs, it is better to do it in a fund. The reason being that you have to buy them in $25,000 lots so it is hard for us as individuals to diversify. Then there is the problem that some mortages are paid off early so you are refunded a bit of money, and you lose the interest on that loan. What then do you do with the bit of money? How do you recover the interest stream.I suspect that you don't buy GNMAs, but there are those who do.GNMAs do not behave like bonds in a mutual fund in that the unit price can drop as the interest rates drop so you can get the worst of both worlds.I used to invest in GNMA funds as at the time the interest rate (actually called dividends) were good. But over the years, I think they did not behave well. But if you must buy into GNMAs, I would suggest the Vanguard GNMA fund. I would say that buying into that fund at less than $10/unit would not be a bad buy because the fund has spent relatively little time below that amount over the years. It is not far above $10/unit now.brucedoebrucedoe
I always hate to disagree with Chris, who I think we have previously declared all knowing, and I do agree with the basic thrust of her views, however….The fact is there are people for whom funds are the only, or the only viable, option: those limited by what is available in employer-sponsored retirement plans, those with increments too small to meet bond or CD minimums, those for whom do-it-yourself is not realistic given life circumstances, and for whom having someone manage money is more problematic than likely deficiencies of funds. This is why I keep trying to understand different funds and how they work to figure out the optimal choices.Jack and I were going back and forth on the index board about another possibility: whether someone with relatively limited resources and a desire to stick to a modest allocation into low investment grade Corporates, given the impossibility of cost-efficient diversification, can match the yields of a long term corporate of, perhaps, long term index fund. This would only be of relevance at times when yields were safely high enough to warrant use of a long term fund without considerable worry about interest rate risk, and of course, we don't really know what that point would be. I think, for now, since the point is moot in the current interest rate environment, anyway, we've agreed matching the fund yield is probably possible with A ratings and below, much of the time, and possible with high investment grade when premiums over Treasuries are high, at least if you can limit commission costs (as with new issues through Vanguard, which currently can't beat CDs).The other issue, which (beyond ease, and I agree laddering minus risk-assessment bond picking is almost as easy as funds) is what Blearynet, I think, is concerned with, is rebalancing. Rebalancing between stock assets and bond/fixed-income assets at times of low interest rates, when there are limited opportunities for bonds to increase in value with falling interest rates and considerable reason for concern with bond funds losing NAV with rising interest rates, is, in the wise words of Professor Greenspan, “a conundrum.” If interest rates were high, either a long bond fund or long bonds (Treasuries and high investment grade Corporates) would make for a good option for rebalancing out of when the stock market was down, providing a nice capital gain, if interest rates fell, to offset losses in the stock market. That's the standard scenario. But this scenario assumes bond values go up when stock values go down, and that is a dangerous assumption when interest rates are already below historical averages (not so long ago, well below historical averages). The problem is laddering does not provide liquidity for deep rebalancing, and if you did want to rebalance with bonds selling at a discount to your purchase price or by cashing in CDs for a penalty, you are looking at losses. So, it may be the sacrifices to return, from a hold-to-maturity perspective, from funds compared to laddering gets compensated for by rebalancing opportunities.If I had bought a 5 year CD 5 years ago for a 5.5% APY (I did), I would have beaten a Total Bond Market Index fund, reinvesting dividends, for 5 years by better than 125 basis points. Now, in this case, if I flip the CD into a new one tomorrow, then the stock market crashes and I cash out to buy stocks, I'm still going to be well ahead over 5 years, if the bond fund doesn't go up. But, if the bond fund responds with a 5% gain from flight to bonds (around a 1% decrease in yield), I'd be better off in the fund, if I want to rebalance.I think there is a lot more research to do on the rebalancing question. The conundrum is the funds that provide the best rebalancing bonus possibilities when rates go down are also the ones at greatest interest rate risk when rates go up. Short term funds provide little gain during falling interest rates and generally lower yields. The Total Bond Index, which might seem like a good compromise, has the leakage problem, with Mortgage refinancing, making it a strange animal from a rebalancing perspective, because it does show gains during flights to bonds in the short run, but then loses out if interest rates stay low enough to encourage refinancing (especially strong during the latest cycle).I think my preliminary thought would be to stay with laddering, and if the stock market crashes enough to warrant rebalancing, cash out CDs or sell bonds for a loss, if necessary, to take advantage of the situation, but don't worry about trying to get a small rebalancing bonus, on the order of 1-2%,, if it means the likelihood of losing more than that by using funds (through leakage or, even more, if interest rates go up). Another possibility might be to use a combination, if available, of the Long Term Index Fund (Vanguard), which has none of those nasty Mortgage Securities and seems to do better for rebalancing if not yield than the Long Term Corporate Fund, and the Short Term Corporate Fund, for liquidity, proportioning them according to what their NAVs were (adjust for realized capital gains) when 10-year Treasuries were last at 6% (as a theoretical inflection point for the bond market), around July-August 2000. I think this would be a way of approximating the Total Bond Index Fund, without the leakage problem. (Or you might assume you've been reinvesting dividends and look at total return.)
I would suggest the Vanguard GNMA fund. I would say that buying into that fund at less than $10/unit would not be a bad buy because the fund has spent relatively little time below that amount over the years. It is not far above $10/unit now.Bruce, the problem is the last time the fund was around the current price, yields on it were around 6,8% instead of the current 5%. Over time, the fund has mostly been above $10/share, because interest rates have declined. If yields on the fund return to 6% (well below historical average for the fund) or above, or even just to 5.5%, the NAV will stay below $10 share.This is the downward leakage I'm talking about, mostly from refinancing. I haven't done the math to see if there have been any realized capital gains, but even if we use the current duration numbers, and they were probably higher in 2000, the fund's NAV should be at around $11/share. In other words (barring realized capital gains) it has lost about 8% to refinancing leakage. We tend not to notice, because the NAV isn't at a loss. But, unlike a Treasury Fund, you are not getting compensated for your lower yield with a higher NAV.
Okay, I rechecked the GNMA Fund using more accurate numbers, but for available dates for doing this (2001-2005). During that period there was a .81% capital return, of which .02% was increase in NAV, so .79% must have been realized capital gains distributions). However, the fund yield dropped from 6.56% to 4.87%, so with a 4.5% duration, the predicted gain would have been 7.6% (I think the duration is low, since there were longer mortgages at the beginning). This means about a 6.8% capital return has disappeared into thin air (or refinancing) over 5 years. It also means the total return was about what you could have had for a 5-year CD, and that was during a time of declining interest rates.On the other hand, if yields go back up over 2006-2010, the fund would theoretically sustain a 7.6% capital loss (I think Jack would postulate higher, because durations would go up) and you total return would be about .75% less than you can get on a typical 5-year CD at the moment (and 1.5% less than Pen Fed). If mortgage rates go up more than that, things would be worse.
On the other hand, if yields go back up over 2006-2010, the fund would theoretically sustain a 7.6% capital loss (I think Jack would postulate higher, because durations would go up)Durations on Ginnies are a pain in the "you watch your mouth." I would agree generally in a rising rate enviroment refinancing slows and more loans are held longer, which would put upward preassure on the duration. Oddly enough it creates a more consistent, predictable, stable cash flow. Pricing these stinkers on the secondary market is ugly. jack
Bruce, what I have is GNMAs. Yes, at $25000 a crack, if I get a shiny brand new one at auction. Sometimes, as described in the post, I've gotten pieces,where part of the principle has already been paid back. Last time I got a used piece of a GNMA it had about $3500 left in it, the rest having been paid back. Correct, no diversifiction. With no credit issues, what good would as Peter Lynch says, diworsification do? If you hold to maturity,the government guarantees timely payment of principal and interest. Don't pay a premium,because you won't get it back. Spreads are such that trading GNMAs will not be profitable. You may be able to trade a fund, but that isn't my game. Best wishes, Chris
"GNMAs do not behave like bonds in a mutual fund in that the unit price can drop as the interest rates drop so you can get the worst of both worlds." You are talking about funds. I do indeed buy GNMAs, not funds. The government guarantees timely repayment of principal and interest. Like a bond, it has a maturity date, which is usually 30 years from date of issue. As a practical matter, the last year or so you are getting maybe $10 a month in principal and $1 or less in interest. Usually there is one homeowner who despite all odds, has not refinanced. Or that last one may pay off the loan or sell the house, and maybe you are paid in full 6 months before what was supposed to be the final payment. With a GNMA you do not worry about unit price,because you are not going to sell it, you are going to let it mature. You put those little bits of principal together with other investment income and perhaps new money,and make your next investment. Until you have enough, you are earning money market rates. When you are old and need the money, you take it, knowing that when the GNMA is exhausted, you won't get a final payment. There isn't need for what Peter Lynch called deworsification. There isn't any credit risk. When you've gotten back a significant part of your investment, if you want to buy another one, you can. In stocks you need various sectors, because some go up while others go down. In jumk bonds, you want a variety of sectors, because if something goes bad, something else is thriving. But with a GNMA, there exists a date by which you will have all your principal back, and in the meantime you will get interest at agreed rate. Yes, as mortgages prepay your cash flow goes down dramatically. For this inconvenience you are paid a slightly higher rate than you would get on a Treasury of equivalent maturity. But if you don't pay a premium and hold to maturity, you WILL get your money back. No such guarantee with funds. Best wishes, Chris
With no credit issues, what good would as Peter Lynch says, diworsification do? Smooth out the timing of cashflows. Maybe all the mortgages in your particular GNMA will refinance, causing the GNMA to end way way early. The bigger your pool of mortgages, the less likely that they all will do what you don't want.
That works great for bonds, but unfortunately not for GNMAs. When the Fed started lowering interest rates in earnest, the refinancing industry had a field day. It didn't matter whether people had been in their house for 1, 3, 10 or 15 years, they all saw the way to save some money was to refinance, and they did. I'd bought a whole, new, shiny untouched GNMA in 2001 and by 2004 there was about 10% left. The same thing happened at the same time to the ones I'd bought in 1993 and 1997. Cash came back in a flood. The more of 'em you have, the more you compound the problem. Best wishes, Chris
That works great for bonds, but unfortunately not for GNMAs. When the Fed started lowering interest rates in earnest, the refinancing industry had a field day. It didn't matter whether people had been in their house for 1, 3, 10 or 15 years, they all saw the way to save some money was to refinance, and they did. I'd bought a whole, new, shiny untouched GNMA in 2001 and by 2004 there was about 10% left. The same thing happened at the same time to the ones I'd bought in 1993 and 1997. Cash came back in a flood. The more of 'em you have, the more you compound the problem.I guess this returns to my original question (or what should have been my original questions).I think, despite Bruce's observation of a safe past NAV entry point, GNMA funds, even for those stuck with or still desiring funds, just don't hack it. When interest rates go up, like other funds, they will suffer to NAV. When interest rates go down, there will be refinancing, and the capital gains will be insufficient to make the total return compensate for falling fund yields.But given Chris' experiences with GNMAs themselves, I don't see why we would choose them. Right now I can get a CD for 5-years higher than any of the Fannie offerings available (Vanguard doesn't have any GNMA's at the moment). Even at 6%, I don't see that as something I would want to lock in for 30 years, and if interest rates do ever go back up to, say 10%, I'd much rather have a Treasury, where I wouldn't have to worry about continuous refinancing when rates came back down. I should also be able to get AA or AA corporates for comparable yields to GNMA's. I understand that having your principal come in gradually could be useful for cash flow, but GNMA refinancing is not predictable and not gradual, plus laddering of other instruments can accomplish cash flow. So, under what conditions would GNMA's be the right choice?
An interesting discussion even if I don't follow exactly the arguements for and against mortgage securities.I have held Fidelity Mortgage Securities Fund (FMSFX) as well as Fidelity U.S. Bond Index Fund (FBIDX) and Treasuries over the years and have been more satisfied with the Mortgage Securities Fund than any other bond fund for monthly income. Recently I have been converting to Treasury bills and notes since the cost is now zero.Just to compare my actual return here is the annual performace. It would have been slightly better in a total bond fund but the actual return was very close to fidelity's claim before costs and taxes. How does this compare to direct investments in GNMA's or treasuries? Would it have been worth the time and effort.Date Investments Returns Avg. Annual Return TOTAL 8/22/1996 - 12/31/1996 23,223 23,731 6.21% TOTAL 1/1/1997 - 12/31/1997 40,631 43,943 10.35% TOTAL 1/1/1998 - 12/31/1998 78,943 82,326 5.87% TOTAL 1/1/1999 - 12/31/1999 133,771 136,237 2.10% TOTAL 1/1/2000 - 12/31/2000 111,551 122,363 11.32% TOTAL 1/1/2001 - 12/31/2001 111,465 119,232 7.35% TOTAL 1/1/2002 - 12/31/2002 150,236 158,020 9.06% TOTAL 1/1/2003 - 12/31/2003 71,725 74,237 3.55% TOTAL 1/1/2004 - 12/31/2004 71,470 74,594 4.43% TOTAL 1/1/2005 - 12/31/2005 99,597 101,465 2.62% TOTAL 1/1/2006 - 9/16/2006 48,978 50,116 3.34% TOTAL 8/22/1996 - 9/16/2006 204,686 249,362 6.11% Fidelity U.S. Bond Index Fund (FBIDX) - 10 yr 6.52 Fidelity Mortgage Securities Fund (FMSFX) - 10 yr 6.20gdm
Date Investments Returns Avg. Annual Return TOTAL 8/22/1996 - 12/31/1996 23,223 23,731 6.21% TOTAL 1/1/1997 - 12/31/1997 40,631 43,943 10.35% TOTAL 1/1/1998 - 12/31/1998 78,943 82,326 5.87% TOTAL 1/1/1999 - 12/31/1999 133,771 136,237 2.10% TOTAL 1/1/2000 - 12/31/2000 111,551 122,363 11.32% TOTAL 1/1/2001 - 12/31/2001 111,465 119,232 7.35% TOTAL 1/1/2002 - 12/31/2002 150,236 158,020 9.06% TOTAL 1/1/2003 - 12/31/2003 71,725 74,237 3.55% TOTAL 1/1/2004 - 12/31/2004 71,470 74,594 4.43% TOTAL 1/1/2005 - 12/31/2005 99,597 101,465 2.62% TOTAL 1/1/2006 - 9/16/2006 48,978 50,116 3.34% TOTAL 8/22/1996 - 9/16/2006 204,686 249,362 6.11% Fidelity U.S. Bond Index Fund (FBIDX) - 10 yr 6.52 Fidelity Mortgage Securities Fund (FMSFX) - 10 yr 6.20
The 8% GNMA I bought in 1993 at 96.5 cents on the dollar of principal I thought was a good thing. First time I'd bought a GNMA. When 10 years later the bulk of the money came back early, that meant that I recouped my discount early. which was a good thing. Reinvesting the money wasn't that much fun. So my answer would be, if you can buy a GNMA at a decent discount (3-5% or so) and it bears a coupon a bit better than you could get at par on a new treasury, it is probably a pretty good deal. Currently new GNMAs aren't worth the trouble, but if your broker has bought a remnant from a client, and will discount the thing to get rid of it, you may do OK, as I will with the $3500 piece bought this spring. As long as you don't pay a premium, you will come out whole. Could you have done better with a treasury? Maybe,especially when there is a fairly steep yield curve. Remember there will always be people who must move for job reasons, houses sold because the owner dies or can no longer take care of it and those mortgages will be refinanced, so only a small fraction of the GNMA will go 30 years. I have one of which I bougnt a piece in 1993 that matures next year. About $105 of principal remains, of which I get back about $10 a month with this month 65 cents in interest. Maybe one homeowner didn't refinance, so you still have it on the books the whole time. 1993-4 was a great time for GNMAs because of the S&L debacle, but it hasn't been that good since. Best wishes, Chris
How does this compare to direct investments in GNMA's or treasuries? Would it have been worth the time and effort.If you had bought a 10-year Treasury on August 22, 1996, the yield was 6.62%. That's without commission, but you probably would have bought near then at auction. And you need to add some compounding for comparison.http://www.federalreserve.gov/releases/h15/data/Weekly_Friday_/H15_TCMNOM_Y10.txtComparing dripping into the fund versus laddering Treasuries would take a lot of work (if even doable). My estimates with the Total Bond Index fund suggest a Treasury ladder over the last 5 or 10 years would end up slightly lower, pretty close in a taxable account, depending on state taxes, and a CD ladder would be close to equal or better, if you got top rates (which is easier now). But remember, this has been in a period of declining interest rates when a fund should show a capital return, which a ladder does not.
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