Mortgage-Based Bonds Offer Good Yield - Risk
IF you think Ginnie, Fannie, and Freddie sound like members of a family, you are right.
They are all bond-like investments that draw their income from the home-mortgage market. The family names - Ginnie Mae, Fannie Mae, and Freddie Mac - were created out of sheer necessity - so that we don't need to use lumbering acronyms for these government-created investments. They're complicated enough as it is!
These mortgage-derived instruments offer relative safety - based on their implicit or explicit government backing - and potentially high rates of return. That makes them popular with some conservative, older investors as well as big institutional money managers.
If interest rates fall further, issues from Ginnie, Fannie, and Freddie might gain in value along with bonds, because their current yields would appear more attractive.
But beware the risks.
Those gains could be negated if declining interest rates prompt another wave of mortgage prepayment and refinancing. When homeowners refinance some of the mortgages standing behind such a security, the yield on the investment drops.
''We're very cautious'' about buying mortgaged-backed securities right now, says Jacob Navon, co-director of fixed-income products at Columbus Circle Investors, Stamford, Conn. Interest rates are now at levels where ''the next wave of refinancing is ready to come.''
A Ginnie Mae security, the most common of the three sibling products, is a share in a pool of home mortgages guaranteed by the Government National Mortgage Association (GNMA), a quasi-federal agency set up in 1968 to promote home ownership. Each month you receive a check that represents both interest and principal. Ginnie Maes are backed by the full credit of the US government. That guarantee covers payment of principal and interest earned by the pool, but does not guarantee a specific yield over time - and thus, the amount of cumulative interest you will receive.
Fannie Mae and Freddie Mac securities are also assembled by quasi-federal agencies, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corp. But they are not formally guaranteed by Uncle Sam. They also return a combination of interest and principal.
Yields on all three products typically run one to three percentage points higher than yields on comparable US Treasury issues. The higher rate stems from the greater risk. Unlike Treasury issues, they are subject to state and local taxes as well as federal taxes. (Treasury issues are exempt from state and local taxes.)
There are three ways to buy these investments: One can buy the individual securities through a broker, buy into a ''unit investment trust'' that holds such instruments, or buy mutual funds that invest in mortgage-backed issues.
Individual bonds. These are expensive. New ones cost $25,000 each, says William Westphal, a broker with A.G. Edwards & Sons, in Clayton, Mo. Older bonds can be purchased in a secondary (resale) market, again through brokers. Their cost will usually be well below the issuing price of the bonds, since payments have already been made on principal and interest. Bonds sold before maturity are usually sold at a discount, perhaps at a loss.
Unit investment trusts. These are diversified portfolios of bonds that are put together by investment houses, and then resold to individual investors. The cost per unit is typically $1,000. The brokerage houses often advertise high yields. But the units may not last to their stated maturity period, given changes in interest rates and refinancing. Moreover, experts say, they have up-front management charges, usually around 4 percent of the selling price.
Mutual funds. For most investors, funds may represent the easiest way to buy mortgage-backed instruments. Some funds start as low as $1,000 for the initial investment. Even that amount may be waived, if the investor makes regular share purchases.
Mark Wright, an expert with Morningstar Inc., a Chicago financial-services firm, says mortgage-backed funds have mostly underperformed US Treasury bond funds during the past six months. Mortgage-backed securities often do better in bear markets than in bull markets, he says, since declining interest rates push up the value of securities with higher rates. Consequently, he adds, ''they are often good investments for persons seeking a defensive position in the market.'' Among funds posting good total returns recently, he says, are Vanguard Fixed Income Securities Fund, GNMA Trust (1-800-662-7447); USAA Investment Trust, GNMA Trust (1-800-382-8722); and Benham GNMA Income Fund (1-800-331-8331).
Mutual funds offset the main disadvantage of individual securities: that principal is returned monthly with income. If you spend the entire amount, you spend your original capital. A mutual fund can reinvest principal - and interest, for that matter.
Finally, a number of other government agencies - from the US Department of Agriculture to the Federal Home Loan Bank - issue notes and bonds. These are exempt from state and local taxes. Many are available through brokerage houses, and can cost as little as $1,000. These have no official government guarantee. Interest is usually only slightly above that of Treasury issues. The secondary market for these agency bonds is also limited.