With volatile markets the order of the day and money markets paying next to nothing, what's a good conservative course of action to earn some decent return with minimal risk? Yes, high-paying dividend stocks might seem to be a good bet, but they have not been immune to drops of 10% to 15% or more in recent weeks.

In the aftermath of the market crash in 2008, some savvy investors have looked to GNMA funds (named for the Government National Mortgage Association). These portfolios invest in mortgages backed by the full faith and credit of the U.S. government.

It may sound like anathema. What solace is there to take in a so-called security backed by the U.S. government? Hasn't the U.S. credit rating been downgraded by S&P? What about the extreme partisanship in Congress? And what about other government-backed mortgage lenders Fannie Mae and Freddie Mac, now under the spotlight for risky (if not downright outlandish or even potentially illegal) activities?

On top of all that, weren't mortgage bonds the very essence of the financial crisis in 2008 and the Great Recession (which might, just might, have a second dip)? To many an investor, it could well seem like throwing good money after bad to go chasing after the instruments largely responsible for our current troubles.

GNMAs also pose unique risks that Treasurys, munis and corporate bonds don't. As one financial planner complains, there is "negative convexity" potential with mortgage-backed bonds. Normally, the duration of most coupon bonds decreases as general interest rates rise and increases as general interest rates fall. With negative convexity, however, coupon bond duration increases as general interest rates rise and vice versa.

"One would expect GNMA bonds to suffer from negative convexity, since, as interest rates rise, fewer people refinance, thereby extending the duration of mortgage loans," says Tony Sapp, a CFP licensee with Commencement Financial Planning in Tacoma, Wash. "This attribute causes mortgage bonds to behave differently within a portfolio than bonds in general, thus causes them to be less attractive than their current duration and credit quality would otherwise seem to suggest."

One of Sapp's concerns, rising inflation and the negative effect that it could have on bond prices, has been widely bandied about over the last two years, both by groups on Wall Street and in Washington. Yet that inflation has failed to materialize. Federal Reserve Chairman Ben Bernanke has promised to keep interest rates low for the next two years.

Still, those who have stayed away from GNMA funds have missed some solid (if unspectacular) returns. When this article was written, the Barclays U.S. GNMA Index was yielding 3.4%. The index reported a 4.80% return for the year ended June 30, 7.14% for the last three years and 7.02% for the last five. Not bad compared with money market funds.

But analysts warn that even though GNMA bonds are fairly safe, they go up and down in value and reflect overall long and short interest rates. They're also vulnerable to early repayment. On the other hand, if you have a two-to-three-year horizon, they make a perfectly credible investment, says Miriam Sjoblom, associate director of fund analysis at Morningstar. After all, the bond fund rates reflect the underlying rates on the mortgages in the portfolios, and they are fully guaranteed by the full faith and credit of the U.S. government.

She downplays the risks of the U.S. backing away from that pledge. First, the GNMA portfolios are the safest of any of the U.S.-backed mortgage providers, notably Fannie Mae and Freddie Mac. And even those agencies are unlikely to lose their government guarantee, regardless of strong opposition to them in Congress, for the simple reason that it would cause untold havoc in the housing market.

First « 1 2 » Next