At its core, fixed income investing is a delicate balancing act. Investors need to weigh their requirements for income/yield and the risks they take with their investments. Too much yield generally equates to too much risk. Too much safety and bonds don’t pay enough in income. But luckily, there are enough varieties of fixed income instruments out there that investors can balance both their needs. And one of the most often ignored bond types offers plenty the safety of government-backed guarantees and high yields.
We’re talking about GNMA Bonds.
GNMA or Ginnie Mae bonds as they are commonly known as, are one of the most unutilized bonds out there. That’s a real shame as these bonds feature many of the same guarantees and stability of treasuries while yielding a bit more. For investors seeking high income with a dose of conservatism, GNMA bonds can’t be beat.
Don’t forget to check our Fixed Income Channel to learn more about generating income in the current market conditions.
Who Exactly Is Ginnie Mae?
You may not be familiar with Ginnie Mae, but odds are you know her relatives Freddie Mac (FHLMC) and Fannie Mae (FNMA). All three play critical roles in the U.S. mortgage market. These firms do not underwrite loans or offer credit to home buyers. That is the bank’s job. What they do is buy pools of mortgages from banks and other lenders, package them together as mortgage-backed securities (MBS), and then sell them to investors. This keeps the flow of capital going, removes risk from the bank’s balance sheets and increases the money supply for housing.
While they perform similar services, the devil is in the details with regards to how these organizations are structured.
Both Freddie Mac and Fannie Mae are considered government-sponsored enterprises (GSE). These were corporations created by the Fed to ease the flow of credit into various industries/sectors. Other examples of GSEs include Farmer Mac for agricultural loans and formerly Sallie Mae for education lending. The key word is sponsored. These firms were simply created and chartered by the Federal government, not backed. Their creditworthiness is solely based on their own standing. This fact was put to the test during the housing crisis of the Great Recession.
Ginnie Mae is a government-backed entity and only buys loans that were supported by the Federal Housing Association (FHA), Department of Veterans Affairs (VA), Rural Housing Service (RHS) and Public and Indian Housing (PIH). These loans come with guarantees that the Fed will step in to prevent the collapse of Ginnie Mae and its securities. Often many of these must include mortgage insurance and other measures to help limit defaults. Because of this, GNMA bonds are backed by the full faith and credit of the U.S. government. So, they share the same high levels of credit quality.
Higher Yields, Still Safe
Despite being essentially risk-free, having high levels of credit quality and being 100% backed by the government, GNMA bonds often trade at discounts to comparable Treasury bonds. The reason is due to the callability and prepayment of mortgages.
When you buy a ten-year Treasury bond, you know that Uncle Sam will pay you back in ten years or on the maturity date. That is set in stone and isn’t changing. The issue with mortgages is, people move/sell their homes, refinance or pay off homes early. This uncertainty of future cash flow creates a different set of risks. And to be compensated for that, investors demand higher yields from mortgage-backed bonds. In the case of GNMA securities, that’s often about 1.25 basis points higher than a Treasury bond.
Right now, GNMA bonds are paying close to 4.49%, while a 10-year Treasury bond is only paying 3.3% and a 30-year is around 3.42%.
Moreover, GNMA features low volatility and has historically held up well during periods of crisis. This includes housing-related issues. During the credit crisis and Great Recession, GNMA bonds produced positive returns, while Freddie and Fannie issued bonds showed big losses.
Don’t forget to explore all Government Bonds to see different options.
Inviting Ginnie Mae to Your Portfolio
Given the bonds’ benefits, safety and higher yields, investors should consider them for their portfolios. This is particularly true for conservative investors or those in retirement. You can buy individual GNMA bonds directly and through a brokerage account. Ginnie Mae’s are issued in $25,000 increments and tend to pay monthly interest. However, that does set up investors for single bond and prepayment risk.
A better choice? One of the many funds and ETFs dedicated to the bond type.
The iShares GNMA Bond ETF (GNMA) is the largest index ETF dedicated to the bond type, while the Vanguard GNMA Inv (VFIIX) and Fidelity GNMA Fund (FGMNX) offer two low-cost and high-ranking active managed mutual funds. By using these funds, investors can get targeted exposure to a huge swath of GNMA bonds, boost their portfolio’s yield and keep the safety of government guarantees.
A key point to remember with GNMA remains taxes. The interest income on them generally is subject to federal and state taxes. Meanwhile, repayment risk can cause capital gains. So, allocating them in a tax-deferred or tax-free account is a good idea.
The Bottom Line
Ginnie Mae bonds represent the best of both worlds. Here, investors can get government backing and safety while being compensated with a higher yield. Adding them to a portfolio is easy with the numerous ETFs and active funds targeting the bond type.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.
