Last week, I discussed the historic decline in global interest rates, and dubbed this phenomenon the Great Yield Compression.
I’ve urged readers to come to terms with the fact that we may be in a low-interest rate environment for a lot longer than most expect.
And the International Monetary Fund (IMF) now appears to be joining me in this warning.
Yesterday, the IMF cut its 2014 U.S. economic growth estimate to 2%, from 2.8%. It also stated that “policy rates could afford to stay at zero for longer than the mid-2015 date currently foreseen by markets.”
The IMF’s conclusion sounds eerily similar to my zombie economy prognosis.
But as I’ve said ad nauseam, chasing yield is not a smart course of action, even though it’s hard to resist the temptation in this environment.
If the market isn’t going to properly compensate us for taking on credit risk, then we should take on, well… less credit risk. That’s exactly the opposite strategy employed when reaching for yield in investment-grade and high-yield corporate bonds.
As you know, U.S. Treasuries have no credit risk. And as it turns out, there is an ultra-safe type of security backed by the full faith and credit of the U.S. government that tends to yield more than Treasuries…
Ginnie Mae Securities
Government National Mortgage Association (GNMA) securities (or Ginnie Maes) are mortgage-backed securities (MBSs) guaranteed by the U.S. government. In other words, like Treasuries, they have no credit risk.
MBSs tend to be more complicated than traditional bonds because of prepayment risk.
We know that as interest rates fall, bond prices rise. But homeowners have the option to refinance their mortgage and this option gains value as interest rates decline. This dynamic causes MBS prices to rise at a slower rate (known as negative convexity in the bond world).
Also, as more homeowners exercise this option to refinance, MBS holders will have to replace their higher-yielding MBSs with newer, lower-yielding securities.
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Basically, the key point is that MBS portfolios underperform Treasuries when market rates decline.
However, this is why MBSs tend to yield more than Treasuries with equivalent maturities. And since rates are already so low, we’re happy to pick up additional yield to forego some potential upside.
Indeed, if interest rates are going to stay rangebound for an extended period of time, then Ginnie Maes are attractive fixed-income investments.
So how do we get on board?
The Gold Standard of GNMA Funds
The Vanguard GNMA Fund Investor Shares (VFIIX) is a mutual fund that invests in Ginnie Mae securities.
The fund has been given a Morningstar Analyst Rating of Gold because of its combination of outstanding characteristics, including an impeccable management team.
With an expense ratio of just 0.21%, VFIIX has a lower annual fee than most other intermediate-term government bond funds.
It pays monthly interest, and has a yield of 2.43%. This may seem miniscule, but the fund actually has a tremendous historical risk-reward ratio due to its relatively low volatility–much lower volatility than corporate bonds with credit risk.
It’s also a solid choice for retirees, or near-retirees, that find themselves with excessive cash allocations, which are slowly being ravaged by inflation.
Bottom line: For investors looking to buck the trend and actually reduce credit risk in their portfolios, the VFIIX offers a safe, higher-yielding alternative to Treasuries.
Safe (and high-yield) investing,
Alan Gula, CFA