GNMA funds may regain their appeal

MUTUAL FUNDS

May 22, 1994|By WERNER RENBERG | WERNER RENBERG,1994, Werner Renberg

GNMA funds -- the mutual funds that are primarily invested in mortgage-backed securities guaranteed by the Government National Mortgage Association (Ginnie Maes) and backed by the full faith and credit of the Treasury -- perform best when interest rates are stable.

In the last year, when rates have been anything but stable, these funds have performed poorly.

First, rates fell, influencing homeowners to refinance the high-yield FHA and VA mortgages that, packaged in pools, had backed many Ginnie Maes. This generated tides of cash from principal prepayments that fund portfolio managers had to invest in lower-coupon pools.

Then the Federal Reserve began to move rates upward, and prices of Ginnie Maes were slashed along with those of other debt securities.

The result: a total return of around minus 3 percent for the first four months of 1994 for both Salomon Brothers' GNMA Index and the average of the GNMA funds tracked by Lipper Analytical Services.

For the 12 months through April, both were essentially unchanged -- a sharp contrast with the 7 to 8 percent average returns of the last three years and the 9 to 10 percent average of the last five.

Now that the Fed's Federal Open Market Committee long-awaited May 17 meeting -- and a half-percent rate boost -- is behind us, are rates going to be more stable at last, reviving Ginnie Maes' appeal?

If you believe so and don't yet own shares of a GNMA fund, you may want to think about buying them -- provided a fixed income fund would fit into your investment strategy and provided you are mindful of the risks that characterize such funds.

If you already own one, you may begin to feel better, having held on and endured the turbulence -- unlike many other investors who redeemed their shares, requiring fund managers without adequate reserves to raise cash by unloading Ginnie Maes at the worst time.

After all, Ginnie Maes do have an attraction that should not be minimized: income that's typically 0.5 to 1.0 percent or so higher, depending on market conditions, than that paid on Treasury securities of comparable maturity and similar credit quality. (Ginnie Maes backed by 30-year mortgages have effective maturities below 10.) The premium is what you get for accepting Ginnie Maes' risks.

If you bought a GNMA fund before the recent rounds of mortgage refinancing, you have been disappointed as your dividends fell with interest rates.

But now that rates have increased and prepayments -- while still high -- have gradually begun to decline, GNMA funds' monthly dividends may have stopped slipping. They could rise again before long, reflecting the higher coupons of Ginnie Maes now being issued.

In considering GNMA funds for your portfolio, take into account a couple of factors that are important to remember when searching for any bond fund: sales charges and annual fees. Whatever you pay in commissions is money that won't earn income for you. Whatever a fund pays in annual expenses is money that's not paid to you in dividends.

GNMA funds also differ in investment policies. Some invest only in Ginnie Maes while others also buy Treasury securities, to benefit from drops in interest rates that can hurt Ginnie Maes.

Some managers invest in higher-coupon Ginnie Maes to boost income but expose themselves to prepayment risk. Others try to guard against prepayments by buying lower-coupon securities but sacrifice income.

Paul D. Kaplan, a senior vice president of Wellington Management Co. who took over Vanguard's GNMA Portfolio when long-time manager Paul G. Sullivan retired in April, is almost fully invested in Ginnie Maes.

After allowing cash reserves to build up to 8 percent of assets, Kaplan has been "putting the money back into the market" and gradually worked cash down to about 1 percent. Having been hurt by prepayments last year, Sullivan and Kaplan have brought down the fund's average coupon by buying securities at par or discount.

Thus they reduced the portfolio's average from nearly 9 percent in January 1993 -- above the then current market rate -- to 8.1 percent, approximately the current coupon rate.

Martin J. Schafer, a vice president of Invista Capital Management Co. and portfolio manager of Princor Government Securities Income Fund since its inception in 1985, stays 99 percent invested in Ginnie Maes. Also "trying to stay away from prepayments," he, too, has been buying par and discount

issues.

With the fund's weighted average coupon down from 7.8 percent at the start of 1993, to 7.17 percent, its principal became more sensitive to changes in interest rates and thus more vulnerable to increases.

Denis Jamison, manager of Lexington GNMA Income Fund since 1981, has about 70 percent of its assets in Ginnie Maes, and about 70 percent of that is in multi-family housing paper to be better protected against prepayments and earn more income, too.

Able to take significant positions in Treasury securities, he put 20 percent of assets into T-bills when he turned bearish at the end pTC of 1993, then sold some bills and Ginnie Maes in February to be about 20 percent invested in 25-year Treasury bonds.

Although many homeowners have refinanced, prepayments remain high despite higher interest rates partly because of the time it takes from a homeowner's refinancing to a Ginnie Mae owner's being paid.

Having refinanced his mortgages three times since 1981, Kaplan feels that homeowners who keep high mortgages aren't being rational.

Did he refinance last year, too? "No," he said, adding:

"I don't have a mortgage anymore. I hate being in debt."

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