In managing the Vanguard GNMA Portfolio -- the oldest Government National Mortgage Association fund -- since its inception 12 years ago, Paul G. Sullivan has achieved one of the best performance records among over 1,000 bond funds.
Like other leading bond fund managers, the senior vice president of Wellington Management Co. has had to be skillful -- and perhaps a bit lucky -- in deciding which securities to buy and sell as well as when to buy and sell them. Like his peers, he has had to deal with unexpected fluctuations in interest rates while being fully aware that no one can consistently predict them correctly.
But like those who manage the 40 other GNMA funds, Sullivan also has had to contend with an even greater challenge: the uncertainty of how homeowners with mortgages will respond to rate reductions.
"As difficult as it is to predict interest rates," he says, "it's impossible to predict what millions of homeowners are going to do."
It's easy to see why this is a concern to Sullivan and his competitors when you remember the prepayment risk that characterizes GNMA funds and the emphasis that they put on trying to reduce it.
GNMA funds invest primarily in mortgage-backed securities approved by the Government National Mortgage Association, a U.S. government corporation.
Some also blend in U.S. Treasury securities and cash equivalents to moderate share price volatility.
Known as Ginnie Maes, the mortgage-backed securities are issued by mortgage lenders and are collateralized by pools of home mortgages insured or guaranteed by the Federal Home Administration or Department of Veterans Affairs.
GNMA guarantees that the interest and principal of Ginnie Maes will be paid when scheduled, thereby backing them with the full faith and credit of the government (as Treasuries are).
Individual and institutional investors who own Ginnie Maes receive interest and principal payments every month as homeowners pay down their mortgages. GNMA funds usually distribute the interest in monthly dividends and reinvest the principal in other Ginnie Maes.
Prepayment risk -- the risk that homeowners will pay back principal faster than scheduled -- is greatest when mortgage interest rates fall sharply. That's when they have the strongest incentive to refinance.
This forces GNMA funds to reinvest the unscheduled prepayments at lower rates, reducing their monthly income. (If they had bought the Ginnie Maes at a premium, they may also have to take capital losses.)
For assuming this risk, Ginnie Mae investors receive yields that may be 1 percent or more above those offered on U.S. Treasury issues of comparable maturity. It's what makes GNMA funds attractive. Early this year, in the wake of the Federal Reserve's December interest rate reductions, mortgage prepayments shot up as mortgage rates fell to levels not seen in years. This had a pronounced impact on GNMA funds, especially on those that were more heavily invested in high-coupon Ginnie Maes whose mortgages were likely to be refinanced.
Now, fund managers wonder how much of an impact the Fed's latest rate reduction will have. Several believe prepayments will accelerate but don't agree on whether January's level will be reached again.
Whatever their views, they've developed defensive strategies to reduce prepayment risk. In doing so, they've made certain assumptions regarding likely homeowner behavior, even if, as Sullivan puts it, "one has to approach them with a degree of humility."
In maneuvering to adjust their portfolios' interest coupon mixes, managers have less flexibility than they used to. Given that outstanding Ginnie Maes in the market have coupons ranging from 7 percent to 15 percent and that current issues run around 7.5 percent, almost the entire range is priced at premiums.
Generally, they're buying current coupon issues with fresh cash, including managers such as Jack Lemein of the $13 billion Franklin U.S. Government Securities Series, the nation's largest
bond fund, who have tended to buy higher-coupon issues to boost income.
They are especially reluctant to hold Ginnie Maes with coupons of 9 percent to 10.5 percent -- regarded as most vulnerable to prepayment -- but at least some are retaining higher-coupon issues.
Those who own Ginnie Maes yielding 12 percent or more, such as Diane Wheeler of Putnam U.S. Government Income Trust, are keeping them on the assumption that homeowners whose mortgages collateralize these Ginnie Maes would have prepaid in January if they were able and willing to do so.
Nor are coupons the only basis for selecting what they want to own. Randall Mark of Benham GNMA Income Fund, for example, checks Ginnie Maes' ages. He's avoiding those between three and five years old, which he believes are most susceptible to refinancing. Barbara Kenworthy, who manages both Dreyfus' Premier GNMA Fund and Dreyfus GNMA Fund, looks at geographical origins. She contends, for instance, that Southerners are less likely to refinance than Northeasterners.
1992, Werner Renberg