Ginnie Mae – why hast thou forsaken me?

For quite some time now, many of our clients have had questions about the notable lack of exposure to (either through bonds or ETFs) the mysterious entity known as the Government National Mortgage Association, or “Ginnie Mae.”  For that matter, we have avoided just about any mortgage bond exposure in our portfolios.  Why is that?

By way of background, GNMA does not issue, buy, or sell any mortgages.  Rather, GNMA is the name of the guarantor federal agency standing behind loans made and/or guaranteed by other federal agencies, such as the FHA (Federal Housing Administration) or the Veterans Administration.  Mortgages made by these agencies and guaranteed by GNMA are typically pooled together and sold to investors as GNMA mortgage bonds.  As such, they bear no credit risk and carry the same AAA as the US government (oops, AA+ if you listen to S&P).  And, yet, take a look at the price of a popular GNMA mutual fund, the Vanguard GNMA Fund (VFIIX) over the past 90 days:

 http://www.nwic.net/wp-content/uploads/2013/07/VFIIX.gif

This 4.5% drop over the quarter (truth: it dropped 5.6% in just 45 days!) could come as quite a shock to those of us accustomed to the usual strong income and price stability demonstrated in the years leading up to this.  The  reason lies in a unique characteristic of mortgage bonds that individual investors sometimes overlook.

When interest rates in the market go up, the conventional reasoning is that the new, higher rates available to investors put the old existing interest rates to shame, and the price of an old bond must go down to entice new buyers.  Conversely, if interest rates generally offered go down and you hold an older bond with a swell, higher rate, then folks will clamor for it and you should be able to sell your bond at a slightly higher price.  Mortgage bonds are no different, except for a wrinkle in when & how you get your money back.  A traditional bond has a set maturity date that can bail you out if you end up not liking its interest rate.  For example, if we own for you a 1% GE  bond that matures at the end of 2015 and rates go up in the market, we always have a couple choices: sell the bond (perhaps at a lower price) or be patient and wait for the bond to pay off in a couple years.  The longer we may have to wait for the bond to pay off the worse that option is, so you can start to see why longer maturity bonds drop more in price than short term bonds do when rates go up.

The specific challenge with mortgage bonds is that they have the unfortunate ability to effectively lengthen their maturity as rates go up: exactly the time when you want bonds with shorter maturity dates!  To see how that is, consider our GE bond maturing at the end of 2015.  It pays some modest amount of interest every six months and then the full face value of the bond on the maturity date.  And that’s it: nothing else, just a couple small payments during the year and a big fat check at the end.  Now think about your own mortgage and how that’s different. You most likely have a mortgage that has a set maturity date far off in the future, but the reality is very few of us actually take out 30 year mortgages and then dutifully make 360 payments in a row to our bank.  Have you ever moved? Then you paid off a mortgage early and replaced it with a new one.  Ever take advantage of lower rates to refi your mortgage? Then what you really did was pay off your mortgage early and got a new one with better terms.  Might you be one of those folks who adds some extra payment each month to pay off the mortgage more quickly and save interest along the way? In that case, your 30 year mortgage might really turn out to be a 20 year mortgage.  In fact, these kind of things happen so frequently that the average length of time Americans really keep their 30 year mortgages is just seven years! And so this is also the expectation of investors who buy mortgage bonds: they may have a stated maturity date of 30 years, but everyone fully expects them to pay off early. 

When interest rates go up and bond prices go down, though, things get a bit squirrelly with the assumption that the 30 year mortgages will really be seven years long.  In fact, what we see when rates go up is that people don’t look to refinance their existing mortgages: they keep them as they are.  And when the economy is still struggling and people are a bit unsure of their finances, jumping jobs to relocate and making extra payments on your mortgage goes out the window pretty quickly, too.  All of these factors act to make our assumed seven year mortgage bond start to look a lot like a 10-15 year average.  When interest rates are going up and bond prices are coming down, would you rather have to wait  7 years to get your money back or 15 years? 

We manage bond portfolios here at NWIC with a strong preference for certainty. We like to be fairly certain we will be paid back, so we only buy investment grade bonds.  We like to be fairly certain clients won’t be rocked by changes in interest rates, so we like to buy bonds that generally mature within 10 years (and much less than that today).  So when we consider mortgage bonds, be they GNMA bonds or funds/ETFs that buy GNMA bonds, we get a bit uncomfortable when a reasonable seven year wait for our money can become a 10-15 year wait at exactly the wrong time.  To be sure, GNMA bonds/funds/ETFs are legitimate and well-established investment vehicles that offer safety of principal and reasonable income, but the last 90 days have shown us that these characteristics don’t always mean price stability, too.

Behavioral Finance highlights

Miss our recent open house presentation? Here are a few highlights from our Behavioral Finance discussion.

 

 
To keep up to date, follow Northwest on Twitter.

 



Economic Outlook–Conerly Charts

View the latest charts and comments on the U.S., Oregon, and Washington economies from Dr. Conerly of Conerly Consulting.

We are pleased to re-post Dr. Conerly’s July charts for our clients. Please see his site for more data and comments: www.conerlyconsulting.com. Click the images below for larger versions.

2013.07_3 2013.07_1 2013.07_2

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

To keep up to date, follow Northwest on Twitter.

 



Northwest Q2 Letter

Dear Clients:

Before we discuss investments, we have a few other topics to cover.  A transition in life is typically accompanied by a long “to-do” list. Occasionally some of the details don’t make your list and thus are never addressed.  Don’t let changing your beneficiaries be one of the tasks that gets overlooked!  At the time of death the current beneficiary on your account will be the one to receive the proceeds of your IRA or Trust even if it’s no longer your intent to have that person as the beneficiary.  For your IRA accounts, you can either contact your custodian to get a Change of Beneficiary form, or contact us and we will send you the form.

We want to connect with you.  Many of you know we have a blog linked to our web site (www.nwic.net ) where we discuss topics of interest in the capital markets and other areas of client interest.  We are also on Twitter, where we tweet links to our blog comments in addition to other information you will find valuable.  If you are on Twitter, please search for @NWInvestment and follow us so you can stay up to date.  Finally, if you are a LinkedIn user, you can connect with our company page.

Stocks

Stocks continue to have an exemplary year, as the S&P 500 was up 13.8% through June 30th.  The long run annual average for stocks hovers around 10% (depending on exactly what you look at), so this is shaping up to be a rewarding year.  There are concerns on the horizon, however, and that has led us to allow a bit more cash to build up in client accounts than normally would be there.  Perhaps the most significant factor is the interest rate environment – please read the “Fixed Income” section of this letter below for more details.  In addition, most foreign economies are growing very slowly, if at all, and earnings gains for businesses here at home look to be somewhat muted in the second half of the year.

All in all, we are somewhat cautious right now.  We spend our days sifting through a variety of informational sources looking for good investments.  Those good investments are elusive currently.  There are certainly a lot of well-run, growing, healthy businesses listed on the stock exchange – the problem is valuation.  We are looking for a margin of safety, and the pickings are slim in that regard.

Most of you will be aware that we sold the majority of our REIT position in the second quarter in our Model portfolios.  We have felt for a while that valuations in this space were stretched.  Where once yields well above 6% were commonplace in this asset class, the yield on the REIT ETF fell below 3% earlier this year.  That was not an attractive risk-return tradeoff in our view.  Proceeds have gone to small cap stocks and preferred stocks.  If you have a custom allocation (i.e., not one of our Models), we will need a signed change of allocation form if you want to follow our recommendation.

NW Equity Income

The current yield on the Equity Income Portfolio stands at about 2.9% weighted by position size, which is just about the lowest it’s been in the history of this portfolio.  Primarily, this is a function of a run-up in stock prices.  With income in short supply for investors, many who would ordinarily purchase bonds for income have instead purchased dividend-paying stocks.  The cautionary note here is that the risk of stocks compared to bonds is apples to oranges.  A given stock may have an attractive yield of, say, 4%, but if that stock falls in price by 20%, that is real pain to the investor.  A bond may only yield 1% (or whatever) in this environment, but the kinds of bonds we purchase are very unlikely to have a significant price decline like a stock.

Note that many clients have holdings that were purchased over the last several years and their yield based on their cost could well be between 4%-5%.

NW Blue Chip Growth

While our buy/sell activity was fairly muted in Q2 in Blue Chip Portfolios, there were a fair number of holdings who announced dividend increases.  Examples include Oracle, which doubled its dividend to $0.12/share, PepsiCo which increased its dividend 6% as it continued with a long string of increases, and Johnson & Johnson, which pushed its dividend up another 8.2%.

Many companies also continued to repurchase their shares.  Both of these actions serve to return excess funds, which are not needed to reinvest back into the business, to investors.

NW Smaller Companies

We added one new holding to the Smaller Companies portfolio during the quarter:  Navigant Consulting (NCI).  NCI, a specialty consulting firm, provides dispute, investigative, economic, operational, risk management, and financial and regulatory advisory solutions to companies, legal counsel, and governmental agencies facing the challenges of uncertainty, risk, distress, and significant change in the United States, the United Kingdom, and internationally.  NCI has shown increasing profitability over the last few years, has a good balance sheet, and offers good potential returns to shareholders.

In other news, Advent Software, a current portfolio holding, announced it would pay a special $9 per share dividend out of cash on hand as well as utilizing its debt facilities.  This move to reward shareholders was announced in Q2 and should be received into client accounts on July 9.

Bonds

The second quarter of 2013 started innocently enough with the interest rate on the 10 year US Treasury note at 1.87%.  In fact, yields actually continued to move lower through April, reaching a low of 1.66% by May 1.  However, some pieces of good economic news with respect to personal spending, consumer confidence, jobless claims, and inflation started a push on interest rates gradually upward through mid June to 2.2% as the markets saw an improving economy that might someday be able to stand on its own two feet.

However attractive the concept of a healthy economy that is self-sustaining might be, the fixed income markets weren’t quite ready for the same assessment from the head of the Fed, Dr. Ben Bernanke.  On June 19 he had the audacity to suggest that at some day in the future the Fed would not need to feed the US economy $85 billion each month.  Mind you, he said that day was not now, and he added that rather than taking away $85 billion/month he might just reduce it somewhat. Nonetheless, within 5 days interest rates on the 10 year jumped to 2.6% and pundits predicted higher & higher rates and an imminent bond market meltdown. Thankfully, we are not in the business of entertainment – we manage your money as your fiduciary – so some perspective is in order.

In the business entertainment world (you know that Cramer and CNBC are in the entertainment business, right?), the 10 year US treasury bond is an important rate for a range of things and is closely followed.  Many residential mortgage rates are set based upon the 10 year, and general corporate borrowing can be affected by its level, too.  So, as a barometer of the cost of money, the 10 year has its place.  And, if you owned the 10 year treasury as rates have increased the price of that bond has gone down.  The 10 year treasury on May 1 had the market price of $103.33 (and a yield of 1.63%), and by the end of June its value had dropped to $96.17 for a 6.9% drop in the span of just 60 days!

Contrast that with changes on the price of the 3 year US treasury.  Today we manage our Intermediate Fixed Income bond portfolios to have short maturities (on average) that are much closer to 3 years. The graph below shows how these two different bonds behaved during the May and June periods of this year.

bondsThe white line is the price of the 10 year treasury (what Jim Cramer & Rick Santelli scream about), while the orange line (3 year treasury) is much closer to what Northwest bond portfolios are designed to do.  Both bonds were lower in price during the time period; only one of them makes for good entertainment.  Rest assured, we seek to invest our clients’ bond portfolios for low volatility and safety – not entertainment value.

We thank you for the trust you have placed in Northwest.  Alleviating the financial burden that comes with managing wealth is what we do. Numerous studies show that the individual investor’s emotions take over when it comes to managing their own money and thus they underperform the markets.*  We would be more than happy to have an initial meeting with anyone you know that is feeling burdened by the sudden responsibility of managing their wealth.

Should you have any questions or would like to set up a quarterly portfolio review meeting, please do not hesitate to contact us at 800.685.7884.



Next NWIC Open House Breakfast to be held Thursday, July 18th 9:00am – 10:00am

Please call or email us if you would like to attend our next Open House. We will be discussing Behavioral Finance and the current thinking in the industry.



Some Light 4th of July Reading?

Here at Northwest Investment Counselors, unlike many other investment managers, we maintain a spreadsheet on the S&P 500 which includes key fundamental data on every member of the index to assist us in identify attractive investments for both the Blue Chip Growth and Equity Income strategies. With the second quarter having just ended, we thought we would share some insights. To compile our data, we review every annual SEC 10-K filing for companies in the S&P 500. From this, we develop two of the three factors used in our valuation model; the third factor, sentiment, is compiled from data not contained in 10-K filings. The goal of using this data in our research process is to make sure we are fishing for investment ideas for clients in the most attractive parts of the market based on quality and value. Keep in mind that this is just one of the research tools we use for clients in our disciplined equity investment process.

We split the results into quintiles, or groupings of 100 stocks, with quintile 1 being the most attractive and quintile 5 the least attractive. The first chart below displays the average stock price returns (no dividends) for the value factors (blue bars) we use and the average stock price return for the S&P 500 (red bar) both for the second quarter. The rankings are calculated from data at the beginning of the quarter and then price performance is graphed over the following quarter. We repeat this process every quarter.

There isn’t enough room in this blog post to detail the formulae and all of the data adjustments, but suffice it to say that the value factor represents the price of a stock divided by the income it generates (price/income)–lower being ranked higher. There was a strong value component to what performed well in the second quarter and what did not (See Chart 1. Value Rank). The red bar shows that the average S&P 500 stock return during the second quarter was a little over 3%. Don’t confuse this with the return on the S&P 500 you may read about in the paper as that performance number is weighted by the market capitalization of the members of the S&P 500; it can and generally will be different. The first blue bar shows that the average stock return for the second quarter for the top 100 companies (first quintile) in the S&P 500 ranked according to our value factor at the beginning of the quarter was about 7.5%. The other quintiles either equaled the return of the S&P 500 (second quintile) or fell well short (quintiles four and five). The goal of this factor is to weed out glamour stocks (those that are most expensive) and focus on reasonably priced investment ideas.

Value Rank

Chart 1. Value Rank

Chart 2 below displays the quintile average stock performance for the quality rank (blue bars) compared to the S&P 500 (red bars)–again, the stock performance is for the second quarter for rankings at the beginning of the quarter.  Our quality rank, to summarize, captures the ability of a company to efficiently use their capital to generate a return for stockholders.  The top three quintiles (300 stocks) all exceeded the S&P 500 average stock return in the second quarter, while the poorest (quintile five) came up well short.  The goal of this factor is to weed out poor industries or poorly managed companies.

Quality Rank

Chart 2. Quality Rank

For the sake of brevity, we will skip the details on the sentiment rank for this blog post.  Overall, we equally weight the value, quality, and sentiment ranks to create our Quantitative Value (QV) summary statistic, which is displayed in Chart 3 below by quintile (blue bars) compared to the S&P 500 (red bar).  There was a solid relationship between the rank at the beginning of the quarter and the subsequent performance over the second quarter (just what we want to see).

QV Rank

Chart 3. Quantitative Value Rank

Our Quantitative Value strategy is composed of 50 stocks from the top quintile (top 100) while candidates for inclusion in the Blue Chip Growth and Equity Income strategies receive further scrutiny by our analysts since our target investment horizon is many years for Blue Chip Growth and Equity Income (plus an attractive dividend yield), not just the subsequent quarter.