Give Me a Ginnie Mae Any Day
They sound complicated and get a bad rap; however, for risk-averse investors who include bonds in their portfolios, this much maligned mortgage-backed security (MBS) can offer generally lower risk, a higher yield, and monthly income.
What are MBS’s?
They are bonds comprised of a pool of mortgages that all share similar features, such as interest rates, scheduled payoff dates, property quality, etc. (i.e., 30-year single-family home mortgages at a similiar fixed interest rate all from the same community).
MBSs are often disregarded by investors because the mortgage-backed security returns a portion of the principal along with each interest payment. This can disturb investors who are not used to being subject to uncertainty in the redemption date of their bond. Owning an MBS is like owning a bond that has monthly calls for a portion of the principal.
Nevertheless, I believe that the following benefits of MBSs far outweigh any drawback.
MBSs are available from private insurers, ranging in credit quality from BBB to AAA (as rated by S&P). Those issued by government-sponsored entities, like FNMA (Federal National Mortgage Association, or “Fannie Mae”) and FHLMC (Federal Home Loan Mortgage Corporation, or “Freddie Mac”) carry an implied AAA rating, and as of September 2008, the Federal Housing Finance Agency became the conservator of these mortgage insurance agencies. As such, the U.S. Treasury has committed to provide necessary funding to support the net worth of these agencies. GNMA (Government National Mortgage Association, or “Ginnie Mae”) bonds carry the full faith guarantee of the U.S. Treasury as to prompt payment of principal and interest, just like Treasury bills, notes, and bonds. This guarantee does not remove market risks if sold prior to maturity.
Ginnie Maes, Fannie Maes, and Freddie Macs are actively traded, and there is a long history of their prepayment and return of principal behavior. If you stick with these bonds, you should find them to be lower risk, easy to buy or sell at market value, and relatively easy to understand. Government agency mortgages tend to yield from 0.75 to 1.25 percentage points higher than a comparable term Treasury Note. Concerns about reinvesting principal that is returned from MBSs can be remedied with a little education and organization. Each month, when you receive the principal and interest payment, put the principal into a money market for easy reinvestment. Your broker may be able to set up your account to separate these portions for you automatically.
How Do MBSs Work?
When you have a mortgage on your home, you make monthly payments to the bank until the mortgage is repaid. In the early years, monthly mortgage payments are made up of mostly interest, with just a small amount of principal payment. In later years, those payments are made up of mostly principal, with just a small amount applied to interest. When you own an MBS, you are on the receiving end of those monthly mortgage payments.
Let’s say that ABC Bank gives you and each of your neighbors with the same quality properties a 30-year, fixed-rate, single-family mortgage. ABC Bank then sells these mortgages, totaling $2 million to $3 million, and sells them to Ginnie Mae, and ABC Bank uses this money to reinvest in new mortgages. A second bank, XYZ Bank sells the same types of mortgages from the same neighborhood to GNMA, which then puts them together into a “pool” of $10 million to $12 million of 30-year, same fixed-rate, same quality, single-family mortgages. GNMA then creates a security, backed by this pool of mortgages, that is guaranteed by the U.S. Government as to the timely payment of principal and interest.
For that guarantee, GNMA charges a service fee which reduces the interest that passes through to investors. GNMA then sells this bond to an investment bank, which divides the bond into $1 million increments and resells them to brokerage houses, which divides them and sells them to investors in pieces as small as $25,000.
Now, when you make your mortgage payment to ABC Bank (or XYZ Bank), the bank passes it through to Ginnie Mae, who passes it through to an investment bank, who passes it to a the brokerage firm and, finally, through to the investor. That’s why these are called “pass-through” securities. Therefore, in the early years of an MBS, the investor is going to receive payments primarily comprised of interest with just a small amount of principal, and vice versa in later years.
Important MBS Issues.
An MBS made up of 30-year, single-family home mortgages has an average life of only 10 to 12 years because of various “mobility factors” that affect repayment of mortgages (i.e., death, job changes, relocation), any of which may cause mortgages to be paid off early.
Significant changes in interest also may have an impact on the average life and yield of an MBS. When interest rates drop, people tend to refinance their mortgages. When this happens, investors will receive payments of principal from their MBS earlier than anticipated, thereby shortening maturity and lessening yield. If interest rates rise, the average life of an MBS tends to lengthen and yield tends to rise. In periods of dramatic interest rate moves, investing in MBSs can be a bit tricky. If you anticipate dramatic interest rate swings, buy a bond with a coupon that reflects your interest rate expectation. If rates are climbing, for example, you can buy higher coupon Ginnie Maes. Your financial advisor should explain how MBSs react to different market conditions.
If you are looking for an investment that provides steady income, low credit risk, and offers market liquidity, government-backed MBSs like Ginnie Maes may be a good option.
If your bond portfolio is greater than $500,000, Sharon Alister can provide a free analytic review to help ensure that your portfolio is in line with your investment goals. Call Sharon Alister at 800-745-7110.