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:
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.