How Do GNMA Bonds Work?

A reader writes in, asking:

“I have the GNMA fund through Vanguard. I’m worried about keeping it because there seems to be nowhere for interest rates to go but up and the general rule is that bonds go down when rates go up. But does that hold true with GNMA bonds as well?”

What Are GNMA Bonds (GNMAs)?

GNMAs are mortgage-backed securities that are issued by the Government National Mortgage Association (a.k.a. Ginnie Mae) and guaranteed by the federal government. For those not familiar with mortgage-backed securities, Vanguard describes them this way:

“MBS are an investment in a pool of mortgage loans, which are the underlying asset and provide cash flow for the securities. MBS are commonly referred to as “pass-through” securities, as the principal and interest of the underlying mortgage loans “passes through” to the investor. All bondholders receive a monthly pro-rata distribution of principal and interest over the life of the security.”

A crucial thing to know about GNMAs (and other mortgage-backed bonds) is that they behave somewhat differently than other bonds.

When rates go up, GNMAs act, for the most part, like other bonds: Their prices go down.

It’s when rates go down that GNMAs act differently. When interest rates go down, people tend to prepay their mortgages (via refinancing). This results in (a portion of) the principal of GNMAs being repaid prior to maturity, thereby forcing the fund to reinvest its cash in new (lower-yielding) bonds.

What this means is that, relative to the price appreciation that other bond funds experience during periods of falling interest rates, the price appreciation of GNMA funds is limited. Note that this does not mean that the price of a GNMA fund will go down when rates go down. It simply means that the price will probably not go up at the rate at which the prices of other similar-duration bond funds would go up.

In other words, GNMAs have the same downside as other bonds, but their upside is limited. In exchange for this limited upside, GNMAs have higher yields than Treasury bonds of a similar duration.

Do GNMAs Have a Role in a Portfolio?

Generally speaking, when it comes to bonds, the market is quite efficient — meaning that, over the long term, most bonds earn returns that are commensurate with their level of risk. That is, it’s difficult to find anything that’s an especially good bargain compared to other bonds.

As a result, unless there is a specific goal you’re trying to achieve other than the typical goal of reducing the volatility of an otherwise-stock portfolio*, I tend not to have very strong opinions about which bonds to use. In other words, in my opinion, the most important point is simply to make sure that the portfolio’s overall risk level is appropriate for your needs (e.g., by using a lower overall allocation to stocks if you decide to use higher-risk bonds).

The risk profile of Vanguard’s GNMA fund includes:

• Virtually no credit risk, because GNMAs are backed by the federal government,
• A moderate amount of interest rate risk — roughly similar to that of Vanguard’s “total bond” fund — given an average duration of 5 years, and
• The aforementioned prepayment risk (though as described above, this isn’t really a risk of loss, but rather risk in the sense that the fund’s upside is limited and the fund’s SEC yield isn’t necessarily a very good predictor for its future returns).

While GNMAs operate a bit differently than other bonds, I think they can be a reasonable thing to hold in a portfolio. That said, I cannot think of a single financial goal for which GNMAs would be better suited than other types of bonds.

*Examples would include minimizing inflation risk (by using TIPS) or improving tax-efficiency in a taxable brokerage account (by using muni bonds and/or Treasury bonds).