Stay Away From Ginnie Mae Bonds?

Q: I've heard that Ginnie Mae bonds aren't a good investment now because of policies the government is pursuing. But your Level 2 Money Rates table lists the Vanguard GNMA Bond Fund as "worth investigating" for an accumulation fund. Why?

A: Ginne Maes are mortgage-backed securities guaranteed by the Government National Mortgage Association (GNMA), part of the U.S. Department of Housing and Urban Development. Unlike Fannie Mae and Freddie Mac (recently taken over by Uncle Sam), GNMA has always been part of the U.S. government, and the payment of principal and interest on every underlying loan has always been explicitly guaranteed by the government's "full faith and credit."

Vanguard GNMA Bond (VFIIX) buys pools of FHA- and VA-insured mortgages guaranteed by GNMA, then derives its income from the mortgage payments made each month by tens-of-thousands of homeowners. In turn, Vanguard pays out some of that money to VFIIX investors and invests the rest in more mortgages.

The biggest risk with a GNMA fund is called "prepayment risk." If interest rates fall, some homeowners will refinance their mortgages. As existing mortgages are paid off, the fund has to invest in new mortgages at lower rates. Rising interest rates pose another risk, because the fund is left holding mortgages at below-market rates. These rate-related risks are why GNMA funds perform best in an environment of steady rates.

As for whether or not GNMAs are a good investment now, if the government eases requirements for refinancing (an idea that's being floated), prepayment risk will increase. And while interest rate hikes seem unlikely right now (given the weak economy) the huge run-up in government spending will create inflationary pressures at some point.

To minimize rate-change risks, Vanguard GNMA is keeping the average "duration" of its holdings very short. For that reason, and because of the fund's extremely low expenses, we continue to believe it is "worth investigating" for an accumulation fund (assuming that your holding period is at least three-to-five years).