GNMA's anyone?

[cute fuzzy bunny]

I'm looking at Vanguards GNMA (a little over 4.5% right now) for parking a little bit of less-than-short-term money (about 15k) with a little more yield than the short term corporate fund.

Looks like the fund manager has positioned the fund well to reduce risk. While rising rates might ding the NAV a little, they should help the yield.

Right now i've got about six to nine months of spending needs in the bank, and another nine months worth in the short term corporate account. I had set up my funds to distribute dividends and capital gains to my checking account, but changed that to the short term corporate account, thinking i'd take quarterly withdrawals from that to keep my bank account at that 9 month level. However the payouts into the short term corporate fund are likely to exceed my spending needs, and that fund will inflate. Unless I get a huge payout in a great year, in which case i'll reinvest part of it back into my longer term investments, I'd like to keep a cash buffer in as high a yield and low a risk instrument as possible. To set the risk level for this money, a one year 5% drop in NAV wouldnt stun me as my draw needs on this money are likely to be in the 12-18 month range and the NAV is likely to recover in this time frame.

So whats the take on the amount of risk of the GNMA fund vs the short term corporate fund, considering the yield of the former is 4.5 vs 3.0. Comparable risk for the yield gain or higher risk?

Just to diagram, because this is not completely simple, this is the plan:

(funds throwing off 20-40k/yr) ---> gnma account containing 15-30k, if it exceeds 30k I'll reinvest half of it --> short term corporate fund containing 5-15k, quarterly withdrawal of about 5k --> Checking account containing about 10k --> my expenses

In this manner, my main funds continue some long term growth that by low historical numbers exceeds inflation and then some. The lower risk (than my funds) GNMA account keeps generating inflation+ a percent or two of interest returns. The short term corporate fund is used essentially as a money market account with nominal risk generating inflation plus a .5% or better interest rate, and my bank account is fully liquid and risk-free.

Is this too complicated for my own good? Is there another vanguard instrument I should consider that offers similar or higher returns with similar or lesser risk? I've also opened an ING direct orange account at 2% but am not sure if i'll use it.

 

[John Galt]

Hello TH. Not sure about you, but it would be too
complicated for me .

I have looked at the ING orange MM account
several times, but was always able to do better
elsewhere. Right now I have substantial money
in bank MM accounts earning 3%. I have not been
much under that rate for about a year now, but I
have to keep moving it around as it is always a
promo rate for only a few months. I have never failed
to find a home for it so far, when the rate ran out.
ING was always my backup.

Here is another comment about my heavy position in
long term bonds. With the yields I have locked in,
plus SS which kicks in in 2006, my annual income
will more than double compared to now. Thus, unless
inflation goes completely nuts, it appears I am covered
for the forseeable future. My other money will have to find a home in different venues, or the same problem
may be faced if any of my bonds are called. But, when
you consider I retired on guts in 1993 and my net worth is way up over 10 years ago, I must be doing
something right.

John Galt

 

[ats5g]

TH,

I was poking around Vanguard's website, and looking at various bond funds. The GNMA fund's duration has an asterisk (*) by it, with the sentence, "Calculated according to Salomon Smith Barney Yieldbook." I checked some other bond funds, and I couldn't find one that had this same note attached to the duration of the GNMA fund.

Also note that if you click on the GNMA fund, and click on the tab furthest to the right, you'll see, "The fund's dollar-weighted average maturity depends on homeowner prepayments of the underlying mortgages." I take from this that if mortgage prepayments are fast and furious, the dollar-weighted average maturity of the fund will fall. BUT, if the mortgage prepayments are few and far between, if interest rates are rising, the dollar-weighted average maturity of the fund could rise.

I checked up on this fund a couple of months ago, and the stated duration was around 2.8. Now, it's around 3.5. Looks more like an intermediate fund now.

If I recall correctly, the calculation of duration of GNMA's depends on an estimation of mortgage prepayments. If interest rates start unexpectadly rising, and mortgage prepayments drop, you could find yourself owning a much longer duration fund. I believe with callable mortgage backed securities (like GNMA's), as interest rates fall (and people refinance) the duration may fall. But as interest rates rise, the duration could rise, making GNMA's more correlated with your stocks!!

There was a previous conversation where I believe I listed some links and some text that explained this phenomenon (negative convexity) better. I think Doug started it. Now, you certainly are being compenated for taking on the higher risks of GNMA's. But, they're not a free lunch, as some people believe. Question is, do you understand the risks of callable bonds, and do you want to take them?

- Alec

 

[cute fuzzy bunny]

Thanks for the info. John, I appreciate your perspective...if I had a conservative guy wearing red sitting on one shoulder giving me advice, it'd be you. I havent figured out yet who the wild investor in white is thats sitting on the other shoulder telling me to buy futures in rare musical instruments is. By the way, if you like white better than red i'm not wedded to the color schemes.

Alec - That vanguard site data is from 11/03. I've seen some fresh info that says its down from 3.5 to between 2.1 and 2.2. Not bad if thats the case, but its not exactly data in a prospectus, its from an analyst that talked to the fund manager. Perhaps he has a bridge in new york that he's trying to sell as well, perhaps not. Supposedly he's been pulling down the duration as hard as he can to make the fund act more like a short term fund if inflation and interest rates start to go up.

Given that shortened up duration, and that I dont think there will be a groundswell of refinances going forward, and knowing that the duration will eventually stretch into the short-intermediate range, and believing that interest rate rises in 2004 will be nominal and later this year (if at all), and knowing that higher rates will be good for the fund in the longer haul, but also knowing nothing about the mortgage bond fund business aside from casual research, and also writing the worlds longest run-on sentence, hence my question about the relative risk.

The thinking is that instead of holding a "safe" hunk (18-24 months) of cash in a money market thats barely treading water, to create a "pipeline" that starts with my core portfolio holdings, which are moderate-low to high in nature. That would pipe into a less risky holding thats still ahead of inflation that I wouldnt be withdrawing from regularly. That would pipe into the short term corporate bond fund (which many agreed was only marginally more risky than a money market). Add my six month supply of liquid cash for regular expenses.

In this manner, I'd have an 18-24 month cash pipe that protects me from needing to sell primary invested assets for up to 2 years in the event I need a larger than normal lump of cash and the market is down. The checking account and short term corp fund give me up to a year to draw assets from the GNMA fund in case it takes a short term hit. It also inflation protects my overall funds somewhat by a tiered risk/reward system that flows both risk and return downhill.

This (I think) allows me to take on more risk and more prospective returns with my core investments, while not seeing my cash buffer suffer from anemic returns.

The real question is: is the (4.69% yield * 12 month gnma fund risk factor) roughly equal to the (2.96% yield * 12 month short term corp risk factor)...is it worth it? Thats the piece I dont know. If the gnma risk factor is just too high or crazy, then i'll shorten the "pipe" and just use the short term corp bond fund with more money in it.

Unless of course someone has another idea for a low-moderate risk investment vehicle that yields 4.5%+...

 

[wzd]

someone posted a link to penfed which has CD rates of:
APR APY

4 year 4.641% 4.750%
3 year 4.163% 4.250%
2 year 3.199% 3.250%

not sure why they are so high....

Wayne