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GNMA vs. RE bubble
Old 06-14-2005, 11:17 AM   #1
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GNMA vs. RE bubble

Does anyone have an opinion on how Vanguard's GNMA fund
might be affected in the event of a blowout of the RE bubble?

Thanks,

Charlie
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Re: GNMA vs. RE bubble
Old 06-14-2005, 11:48 AM   #2
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Re: GNMA vs. RE bubble

GNMAs are backed by Uncle Sam. As such, they effectively have no credit risk. What might be a source of risk is interest rate risk. If the market is bad, homeowners would likely not pay down their loans as fast, so you would have a loger duration than expected. If the market is really bad, there will be a lot of borrower defaults, which Ginnie would make good with cash, so you'd have a shorter duration than expected.
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Re: GNMA vs. RE bubble
Old 06-14-2005, 01:25 PM   #3
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Re: GNMA vs. RE bubble

Quote:
Originally Posted by brewer12345
GNMAs are backed by Uncle Sam. As such, they effectively have no credit risk. What might be a source of risk is interest rate risk. If the market is bad, homeowners would likely not pay down their loans as fast, so you would have a loger duration than expected. If the market is really bad, there will be a lot of borrower defaults, which Ginnie would make good with cash, so you'd have a shorter duration than expected.
Yeah, Ginnies aren't a good place to be if rates really start rising. Part of the problem is the sometimes strange nature of asset backed securities. What could happen in a worst case scenario is this. Rates start rising, meaning that few people will be doing re-fi's on their home. So now you have a 30 year maturity (probably slightly less due to sales of some of the homes) bond that pays a paltry yield, and the market will just hammer it. IF and thats IF rates do go up sharply, GNMA's are one of the worst places to be.

That is why diversification is just if not more important with bonds than it is with stocks. I still own some as part of my bond portfolio, but I take a very long view. I think they are a great asset class, but you don't want to be heavily invested in that kind of environment.

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Re: GNMA vs. RE bubble
Old 06-14-2005, 02:19 PM   #4
 
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Re: GNMA vs. RE bubble

Would you say that the GNMA fund would lose more than say the Long Term Bond Index in a rapidly rising interest rate environment?
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Re: GNMA vs. RE bubble
Old 06-14-2005, 02:48 PM   #5
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Re: GNMA vs. RE bubble

Quote:
Originally Posted by TromboneAl
Would you say that the GNMA fund would lose more than say the Long Term Bond Index in a rapidly rising interest rate environment?
It's really hard to say. Part of the problem is that GNMA's (like all structured securities) have a unique type of interest rate risk. Most mortgage bonds are prepaid to some degree. As rates have been falling the last several years, the speed at which prepayments happed has increased. Should we see a sustained increase in rates, most prepayments will stop, because who wants to re-fi at a higher rate? The metrics used to measure this lengthening of maturity are a little much to go into here (I don't feel like typing that much) The short answer is that they're pretty close.

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Re: GNMA vs. RE bubble
Old 06-14-2005, 03:27 PM   #6
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Re: GNMA vs. RE bubble

I checked Vanguard's website and found the following:

1) GNMA has only been down 1 year since 1990 with a total
return of -.95% in 1994.

2) In that same year (1994) the following Vanguard funds
had worse performance:

Long Term Bond Index .......................... -4.53%
Long Term Investment grade.................. -.53%
Intermediate Term Bond Index............... -2.88%
Intermediate Term Investment Grade..... -4.2%

3) In the 2nd worst year since 1990 GNMA returned 0.78%
in 1999.

4) In that same year (1999), the same Vanguard funds
had worse performance again.

Long Term Bond Index ........................... -7.85%
Long Term Investment Grade ................. -6.23%
Intermediate Term Bond Index .............. -3.0%
Intermediate Term Investment Grade .... -1.53%

It looks to me as if GNMA may be a little safer than these other
funds in bad years. Although the overall long term total
return is less than these 4 funds, the volatility of GNMA seems
to be less as well.

I assume the RE bubble will pop when/if long long rates start
to rise significantly. Conventional wisdom says (per brewer)
that we should expect GNMA to be hit worse that other bond
funds because of the increased duration due to lack of ReFI
activity ...... but that does not seem to be the case for
Vanguard's GNMA.

Maybe this is a case where management adds some value?

Cheers,

Charlie
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Re: GNMA vs. RE bubble
Old 06-14-2005, 11:46 PM   #7
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Re: GNMA vs. RE bubble

Charlie - I've got a lump o' gnma. In my opinion, they're not so bad. A little riskier than short term bonds but with a little better payoff yield to more than compensate for that risk. I wouldnt expect a lot of upside past the 4.5% yield, but I wouldnt expect a loss of principal either.

Right now, bondwise, i'm holding CA INT muni, gnma, high yield, and the stuff that wellesley and wellington hold. I'm not feeling a lot of pressure of potential lost principal from any of them. Yields of 3.5%, 4.5%, ~7% and ~4-5% for the muni, gnma, hi yield and wellington mgt picked bonds respectively.
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Re: GNMA vs. RE bubble
Old 06-15-2005, 07:26 PM   #8
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Re: GNMA vs. RE bubble

Charlie,
Fwiw, I've held Vanguard GNMA fund for about 20 years, and never been disappointed. Even put my Mom into it. Tends to yield about .5% more than comparable treasuries, and I still can't figure out why. Government National Mortgage Assoc. is 100% federal owned agency, holding no mortgage backed securities. (according to my trusty online financial glossary).

I'd say they are a safe place to park bonds -- I have 5% of the Port there now -- mostly I hold Vanguard Intermediate Term Bond Index, though.
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Re: GNMA vs. RE bubble
Old 06-15-2005, 08:15 PM   #9
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Re: GNMA vs. RE bubble

Here's an article on GNMA's from Vanguard:

How interest rate changes affect mortgage-backed securities

I think the main point is that while the duration [or interest rate sensitivity] of treasuries and non-callable corporate bonds and funds remains rather constant, the duration of GNMA bonds and funds can fluctuate a whole lot. I believe that it is recommended you treat the GNMA funds as an intermediate term fund.

It'd sure be interesting to see how mortgage bonds did during the late 70's + very early 80's, with huge swings in interest rates. Unfortunately, googling didn't help on that. I'd imagine that people like Ibbotsen and Lehman Bros would charge for this.

As Charlie has shown, Wellington Management [who manages the fund for Vanguard] has done a pretty good job of managing the interest rate risk.

- Alec
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Re: GNMA vs. RE bubble
Old 06-15-2005, 09:22 PM   #10
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Re: GNMA vs. RE bubble

Thanks for all your replies. I have a big slug of GNMA in my Mom's
account and was getting a little nervous about the RE bubble.
I will just let it rest there as she would get anxious if I tried to
change it now. It looks as safe or safer than the other intermediate
term funds.

Cheers,

Charlie
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Re: GNMA vs. RE bubble
Old 06-16-2005, 02:31 AM   #11
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Re: GNMA vs. RE bubble

I own some GNMA's too. According to Scott Burns:


Question: Would you discuss the risks involved in Fannie Mae and Ginnie Mae bonds and funds as to the interest rate risks and refinance risks?

M.B., Arlington

Answer: The ideal market for mortgage-backed securities is one in which interest rates are relatively stable. In such a market, the investor won't be assaulted with refinancings. The investor also will collect the slightly higher coupon return offered by mortgage-backed securities.

Here's how it works. When you take out a 30-year home mortgage, you pay a long-term interest rate, currently averaging about 5.3 percent. That rate is about the same as the yield on a U.S. Treasury bond of similar maturity, recently 5.35 percent.

The difference is that the average mortgage is paid off or refinanced long before 30 years have passed. In effect, the investor is receiving long-term rates for short-term money.

One measure of this is the average effective maturity of major GNMA mutual funds. Although home mortgages are typically written for 30 years, the average effective maturity of the Vanguard GNMA fund is only 4.7 years.

If you invested in a five-year Treasury, it would yield only 3.65 percent. The Vanguard GNMA fund, however, was recently yielding 4.57 percent. That's one of the reasons I've mentioned this fund in my column.

Is there a catch?

Always. If you want to make a capital gain on your fixed-income investments, mortgage-backed securities aren't the way to do it.

When you own a conventional bond, you know its maturity. You will collect its coupon yield for the life of the bond.

There is no such certainty with mortgage-backed securities. In fact, they work perversely.

If interest rates go down which would give you a capital gain as a bondholder your mortgage will be refinanced away, so you'll never make the gain.

If interest rates rise which would give you a capital loss as a bondholder the effect will be even worse. Instead of lasting five or six years, it may last 30. You'll be stuck with a low yield for the increasing life of the mortgage.

Worse, some GNMA funds sweeten their current yield by paying a premium for high-coupon mortgage securities. That allows them to distribute an artificially high interest rate.

What they don't tell you is that your principal is being reduced because they lose the premium they paid when the mortgages are refinanced at par value.

If you are offered a GNMA fund with an unusually high current yield, it's probably got a portfolio full of premium-priced mortgage securities.

Recently, for instance, Van Kampen U.S. Mortgage A shares were distributing at a 5.39 percent annual rate. At the same time, the 30-day Securities and Exchange Commission yield on the fund was only 2.73 percent, reflecting the amortization of premiums paid.

Van Kampen U.S. Mortgage has followed this policy for years. As a consequence, the total return of the fund has been lower than funds that don't have such a policy.

Vanguard GNMA, for instance, was distributing at a much lower 4.67 percent rate, very close to its 30-day SEC yield of 4.57 percent.



TIPS or GNMA for a cash reserve?

Question: We have about $60,000 in the Vanguard GNMA fund and are adding $1,000 a month through automatic investment. This is a cash reserve fund for us and so must remain relatively liquid.

I recently requested a prospectus from the Vanguard Inflation Protected Securities mutual fund.

Would you please contrast the pros and cons of each in a rising interest rate environment, keeping in mind our short-term purpose?

J.Y., Arlington

Answer: What distinguishes the well-managed GNMA funds from regular bond funds is that they offer a higher yield relative to their effective maturity.

Vanguard GNMA fund, with nearly $19 billion in assets, is the largest of the intermediate-maturity government bond funds.

It has performed in the top 17th, 13th, 15th, 6th and 3rd percentile of its intermediate maturity class over the last 12 months, three years, five years, 10 years and 15 years, respectively.

So it is a good choice for people trying to get a better yield on money they may need to access. Over the last five years, for instance, it has provided an annualized return of 6.81 percent

It is possible, however, to lose money in a GNMA fund even one as good as Vanguard GNMA.

In 1994, one of the worst years for fixed-income investing in history, the fund lost 0.95 percent. In 2003, a year of mortgage anxiety, the fund returned only 2.49 percent. In both years it was still in the top 25 percent of its category.

Vanguard Inflation Protected Securities fund has provided a higher total return over the last 12 months and three years (7.28 and 9.83 percent, respectively, compared with 4.16 and 5.03 percent for Vanguard GNMA).

Those impressive return figures should not be regarded as sustainable. The investment community was skeptical about the first offerings of Treasury Inflation Protected Securities. As a consequence, they had to be priced at a 3.5 percent premium to inflation.

Today investors understand the bonds, so the premium has been substantially reduced. As a consequence, future returns are likely to be more modest.

Neither fund is an ideal choice as a cash reserve. Of the two, the GNMA fund will probably serve you better.
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Re: GNMA vs. RE bubble
Old 06-16-2005, 11:26 AM   #12
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Re: GNMA vs. RE bubble

Somebody correct me if i'm wrong on this. I know you shrinking violets and getting you to speak up is usually a big problem.

The total return on the tips fund includes increasing NAV's. Vanguards tips fund held a lot of those 3-4% coupon tips. The secondary market value of those high yield tips went through the roof, often selling for 20-30% higher than face value. Unless i'm mistaken, that was reflected in the NAV. Thats not going to happen again anytime soon, so if thats true, I believe the above thesis that the tips returns wont be anywhere near as good going forward.

The other thing (again, correct me if i'm wrong...please speak up) is that I believe the vanguard tips fund distributes the inflation adjustment of the tips bonds as a capital gain at the end of the year. This is a bit of a two edged sword...you're paying the taxes on this if you hold tips directly, but you normally dont get the money until you cash the bond. Last time I looked the yield was only something like 1.2-1.3%, but the gain distributed if factored in was giving you ~4.4-4.5% annual payout in total. Right about where the GNMA fund is sitting.

After watching some fed talking head on CNBC the other morning crowing about how great inflation is: "If you take out food, energy and clothing, inflation is nonexistant!" The manequin on the show made a point that most people do buy energy, food and clothing" which the guy waved off. "Well, energy is simply the current overpricing of oil, and clothing is all screwed up because the weather patterns have been off this year".

In other words, we'll take out anything thats shot up, bring it behind the barn and shoot it rather than recognize that something will ALWAYS be out of whack and contribute to higher inflation.

Thats what constantly nags me about tips...not that they wont be super stuff if inflation runs to high single or low double digits again. But that there is a concerted effort to pull down the inflation rate and with tips (and ibonds) that inflation index is the lions share of the return. That ~4.5% annual return from tips today could quickly turn into 3.5 or 2.5% next year.

I dont think the gnma fund will drop below its current rate. It may be slow to offer a higher yield as rates rise due to people digging in and sticking with the low current rates. So I think its a good place for bond holders short money but you may want to look for something else in a year or two or three.

I'm starting to look more fondly at vanguards junk fund. That 7% yield is pretty tempting and the lack of defaults is appealing. I cant easily see any economic changed that may take place over the next couple of years that might increase that default rate, especially given the less junky nature of the vanguard fund.
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Re: GNMA vs. RE bubble
Old 06-16-2005, 12:19 PM   #13
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Re: GNMA vs. RE bubble

TH, that's why I think commodities are a much better hedge against inflation than TIPS or i bonds. In short, the measurement of inflation in the bonds is determined by the gummint, not the market. Don't tell me there is not an incentive to fudge the numbers.

I think that you really have to pick your time to invest in junk. The junk market looks generously priced to me right now. Wait until the next spill, like in April/early May when GMAC bonds went to CCC yield levels.
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Re: GNMA vs. RE bubble
Old 06-16-2005, 12:34 PM   #14
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Re: GNMA vs. RE bubble

Good point re commodities.

I'll take your advice on the junk and wait a while. Seems like the nav never really goes anywhere on the vanguard fund?

I've got this lump of $100k in the ca muni money market, and it looks like as predicted the yield dropped from the 2.7% range down to 2.1%. My tax situation isnt that dire so I was looking for something thats still cash/bondish with a stronger yield.
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Re: GNMA vs. RE bubble
Old 06-16-2005, 01:59 PM   #15
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Re: GNMA vs. RE bubble

Maybe CDs? Pen Fed only tags you with a 6 month withdrawal penalty. Barring that, how about high yield munis?
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Re: GNMA vs. RE bubble
Old 06-16-2005, 03:17 PM   #16
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Re: GNMA vs. RE bubble

Yeah, I took the Penfed route, 5 years, 5% APY as my medium term bond choice recently when rolling over some munis.

One thing about the junk bonds -- just because there haven't been any defaults (100% loss) doesn't mean there haven't been any downgrades, which can lower price and hurt annual capital return, too. However, we can all hope the Vanguard managers will ride those out and get par for them in the end, so it isn't a big deal for long term holders.

I agree that nothing on the horizon makes junk look particularly bad as an asset class -- obviously individual companies will have their pratfalls. I wonder how are those old GMAC bonds doing,
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Re: GNMA vs. RE bubble
Old 06-16-2005, 03:59 PM   #17
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Re: GNMA vs. RE bubble

Quote:
I wonder how are those old GMAC bonds doing,

Doing fine thank you very much. I bought them after the downgrade. Doing my own calculations, i figured that they couldn't run out of cash if they tried in the next 3 years.

9% for 3 year, I'll take that chance.

Th, concerning the Vanguard high yield fund... a couple of comments

1. It can be a really good fund depending on your situation

2. Calling it a "junk bond" fund is very generous. This is a fund that that has 51% of holdings at BB or better and 90+% at B or better so risk wise it's better situated than most similar funds.

3. Duration hovers around 4.4-4.5 so in addition to credit risk, the interest rate risk has been minimzed

Very goof manager tenure too
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Re: GNMA vs. RE bubble
Old 06-16-2005, 04:03 PM   #18
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Re: GNMA vs. RE bubble

Quote:
Originally Posted by saluki9

Th, concerning the Vanguard high yield fund... a couple of comments...

Very goof manager tenure too
I love a fund manager with a sense of the absurd...

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Re: GNMA vs. RE bubble
Old 06-16-2005, 04:09 PM   #19
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Re: GNMA vs. RE bubble

Quote:
Originally Posted by saluki9

Doing fine thank you very much.* I bought them after the downgrade.* Doing my own calculations, i figured that they couldn't run out of cash if they tried in the next 3 years.*

9% for 3 year, I'll take that chance.

Th, concerning the Vanguard high yield fund...* a couple of comments

1. It can be a really good fund depending on your situation

2. Calling it a "junk bond" fund is very generous.* This is a fund that that has 51% of holdings at BB or better and 90+% at B or better so risk wise it's better situated than most similar funds.

3.* Duration hovers around 4.4-4.5 so in addition to credit risk, the interest rate risk has been minimzed

Very goof manager tenure too
Yeah, if you bought GMAC during the recent trip into the gutter, you did good. GMAC is in pretty good shape. Can't say the same thing about GM, though.
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Re: GNMA vs. RE bubble
Old 06-17-2005, 03:43 AM   #20
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Re: GNMA vs. RE bubble

Commodities probably are a better inflation hedge. Everywhere I go in asia, concrete is being poured. A lot of it...

Maybe I'm wrong, but I'm considering some I-bonds for "near term" money. A little like a five year CD on automatic. The penality for I bonds (before 5 years) is 3 months, so not too bad if I want to bail.
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