GNMA avoided the problems facing Fannie and Freddie, Sjoblom says. It is true that GNMA funds are subject to interest rate risk like any bond fund, but Sjoblom doesn't see prepayment as a particularly onerous problem-given that the bond market often telegraphs its movements ahead of time. "They certainly have lower volatility than a stock fund." Through August and early September, investors have seen daily massive movements in the stock indexes, both up and down, of more than 100 percentage points in an hour or two. Those kinds of movements are unlikely in bond funds.
But Sjoblom says they are not a substitute for cash. "They're still an intermediate bond fund with interest sensitivity. So if Treasury yields were to rise, these would rise and could cause losses in the short run. I'm not sure all investors understand that. Everyone should understand, it's still subject to interest rate movement." Still, Morningstar considers these funds very safe with no default risk in investing, she adds.
By way of comparison, the Vanguard Long-Term Bond Index fund, which is arguably more vulnerable to long-term interest rates and default risk, was yielding 4.05% as of September 8, only a 0.6% premium over the average GNMA fund, for arguably substantial additional risk.
Bedda D'Angelo, the president of Fiduciary Solutions Inc. in Durham, N.C., is concerned that investors don't understand the differences between GNMA funds and money market funds. "A GNMA fund is suitable for investors who are taking current income, [but]because it pays out a reasonably decent monthly income stream, most people who invest in GNMA funds are using the monthly income to live on."
For that and other reasons, D'Angelo said she is not using GNMA funds in any of her clients' managed portfolios. She recommends high-dividend stocks like Procter & Gamble, which pays 3.3%. However, even blue chip stocks are subject to volatile market risk, and P&G stock was actually offering a higher yield of 3.4% recently after a one-day sell-off where it lost 1.7% of its value.
Jason White is the director of investments at the Family Investment Center in St. Joseph, Mo., and holds a Ph.D. in economics. White says he understands the risk/reward dynamic of GNMA funds and considers them well worth pursuing. "I direct nearly $100 million in client assets in separate accounts on a discretionary basis. I use the Pimco GNMA fund as a core holding in many of our accounts where a fixed-income allocation is appropriate. I absolutely believe that a GNMA mutual fund is a good strategy as part of a diversified, conservative portfolio."
Vanguard, as noted, offers a well-rated GNMA fund, and Christopher Philips, a senior investment analyst for the Vanguard Investment Strategy Group, says it's important to remember, "There is no such thing as a free lunch. If something looks too good to be true, it probably is." GNMAs that offer higher yields than Treasurys have taken on additional risk. There may be an implicit protection against default, but it's no guarantee. "Whether [that risk] manifests itself going forward, I have no idea." And while the Fed has guaranteed low short-term interest rates, these are no guarantee against inflation-causing higher rates, which would be a negative for GNMA funds, he says.
While Vanguard offers many higher risk funds, it famously cautions its investors to be aware of risk. Philips agrees that risk levels depend on the duration of the mortgages in a given fund and the risk of prepayment. Having said that, he notes a research paper issued by Vanguard last year when there was talk of a bond bubble and lingering worries about the bond debacle in the financial crisis. The paper said that even with the potential for loss in bonds, even in the worst case, in which there was an uptick in rates, the total return investor with a reasonable time horizon would see a much quicker return on his or her investment in bonds than in equities or other riskier investments.
All in all, that sounds like a pretty good endorsement of GNMA funds.