GNMA's, FHA SPEED, DURATION, CALLABILITY OR HOW TO
GET SCREWED BUYING GOVERNMENT SECURITIES
The reason for this commentary is the continued use of government mortgage instruments as conservative investments where neither the investor nor the broker has hardly any idea of how they actually work. It is true that the underlying mortgages are guaranteed against default by the government, but that is effectively the only guarantee offered. The underlying value of the principal can go up or DOWN and for reasons that are quite dissimilar to regular bond investments.
GNMA's do pay more than Treasury instruments of similar maturities, but, unlike Treasury instruments, you are not sure when the maturity will actually occur. That, therefore, becomes the first basic issue. Most mortgages are for 30 years but they will be paid off, as a group, over a shorter period of time due to refinancings, moves, etc. A WSJ article in 1992 indicated that if interest rates were not changing, the expected maturity was 15.40 years (you could expect your 30 year mortgages to be effectively paid off in half the time). This is referred to as FHA speed- the "normal" time frame for a mortgage to be paid off. This speed changes as interest rates in the economy changes and becomes the major focal point for the understanding- or misunderstanding- of GNMA, FNMA's, Freddie MACS and other passthrough mortgages securities. This will be addressed further below. .
The second definition is called duration. This has to do with when- and how fast- you will get your money back from your investment. Normally, the earlier you get back your investment, everything else being equal, the better off you are.
Let's assume you own two "regular" bonds- Bond A with a 12% coupon rate or yield and Bond B with a 6% yield, both with maturities of 10 years. Which one will get you your money back faster? It's easy to see- Bond A. $120 a year ($1,000 face value x .12) is more than $60 a year. It also means it has a shorter duration- the present value of the income stream. Everything else being equal, you would therefore prefer bond A (some caveats apply to various interest rate scenarios). Of course, one must also realize that Bond A will cost more than Bond B due to its higher yield and this must be addressed in the equation. One must also consider ratings, and the invariable call dates on each bond (discussed below but for this example, I have assumed none) makes the calculation difficult, but it can be done.
What becomes less apparent is in the use of bond funds with 50 or 100 different bonds. One fund may have some bonds paying 6%, 8%, 12% etc., the other may have 5%, 7%, 13% and so on. Attempting to determine the duration of each fund is NOT the same as the average weighted maturity- though that might give clues and will undoubtedly be used in the calculations. Assuming, through the use of mathematical analysis with present value concepts, that Bond Fund A had a shorter duration, you might buy that fund. This is not perfect however since, if rates in the economy were increasing, it might be worthwhile to lock in high rates by using funds with longer durations.
The next concept is callability. A bond is callable if it is sold as such by the issuer and allows the issuer to pay off investors EARLY by giving them all their money back (sometimes with a premium, but none is assumed for all examples). They would do so under this circumstance. Assume economic interest rates were at 12% and the issuer issued bonds yielding 12%. Also assume that interest rates in the economy dropped in the next five years to 6%. The issuer would much prefer to pay off those old bonds at 12% and issue new ones at half the rate they are currently paying. And if the bonds are callable, that is exactly what they can and will do. The return on the investment in bonds is usually based on the yield to the first call date though other returns are calculated as well.
Now, maybe you had a problem grasping each issue I put forth. But what you do need to recognize is that there is some reasonable method in determining the value of a regular bond fund and how they might work given a set scenario.
But the analysis goes further in that the investor with a callable bond is caught in a messy dilemma if the bonds are actually called away. The investors now get back their money a lot sooner than they had hoped and now have to go out into the marketplace to invest the money all over again. And trying to get 12% again in a 6% market would be difficult at best- UNLESS THEY WERE WILLING TO TAKE MORE RISK. This therefore becomes the Risk of Reinvestment- an investor getting back their money and having to reinvest it all over again. (This is a basic definition necessary for all investors.) Of course, should rates have risen, they would be able to get higher returns than from the old investment. But, if rates had risen, a corporation or municipality would NOT call the bonds due prior to the stated maturity, so it tends to be a moot point.
But that all changes with GNMA funds- which people buy since they are portrayed as some of the most conservative investments available. A GNMA fund is a grouping of various mortgages- maybe yours- into a big pool in which the monies that are paid on each mortgage is transferred (minus some costs to the local bank and GNMA for acting as servicing agents) to the investors. Investors receive both the interest AND the principal from the mortgages which occur each month.
But I need to further describe a major difference between GNMA's and regular bonds and the real problem in why GNMA's are not conservative. (Yes, they can be fine in a stable interest rate environ, but no one can ever guarantee- even suggest- that rates will stay constant within a 1/4% to 1/2% range. Just take a look at the movements of the FED over the past few years.) Remember, if you own regular bond, they may be callable. And if so, the call dates are SPECIFIED on the bond. The issuer does NOT have the right to call these at just any time they want.
However, a GNMA has unlimited/infinite call dates- not just the two, three, four that a bond might have. In such cases, it is the underlying mortgagors that are apt to pay off a mortgage (refinance) when rates go down. It's the same as your mortgage at 12%. If rates dropped to 7%, you may go out and refinance. In such case, the purchaser of your mortgage in the GNMA pool gets, potentially, a lot of their money back quickly and faces the Risk of Reinvestment. And they have no idea just how bad the risk may be since it is solely up to the homeowner to make the decision to refinance. Further, recognize that this does not have to be an absolute factual decision but an emotional one. If the economy is good, the job market stable, etc., they might just decide to refinance even if the rate change is relatively small. Sometimes people do things simply because their neighbors did. Or they were scared that if they didn't do it now, they wouldn't have the chance later on, etc., etc.
And in reviewing the drop of rates prior to 1994, there were hundreds of thousands of homeowners that refinanced. Further, the first mortgages to be refinanced were those having the highest interest rates. Later, as rates dropped further, more and more people did it-sometimes to save just 1%. And, as you may surmise, the investors in those GNMA's got back tons of money that they had to reinvest at lower and lower rates.
So what is the impact on the GNMA fund and the investor? Well, the risk of reinvestment has already been addressed and that is a negative. But the value of the GNMA can do poorly as well- AND DOES. The market realizes that the GNMA will lose most of its higher rates bonds and the value may therefore DECREASE. Having a low stated duration may be useless-- and in fact, misleading. The duration may be based in large part on the retention of the high yield bonds in the portfolio- and they'll be GONE. So duration can actually go up because the lower rate mortgages that remain in the portfolio are apt to stay there for a long time - another reason for a value drop.
Also note that as interest rates drop with regular bonds, the principal goes UP- and that happens because the bonds cannot be called until the pre determined dates are up. Not so with GNMA with their infinite call dates and the loss of the high yield mortgages. Also recognize that if the market thinks there will be more decreases, the value can drop further. The point with some of this commentary is the same analogy with stocks. Just because the book value of a company says it is worth "X" dollars does not mean that that is the value of the underlying stock. It is a perception by the public of future and the income (or lack thereof) that can drive the value now. Regular bonds have stated yields for some set period of time. GNMA also have stated yields but they are NOT set for any period of time and are therefore open to interpretation of future events.
To give you an idea of the financial implication, look at the years prior to 1994. Regular bonds were making their stated yield plus the appreciation- making from 12% to 14% total return. GNMA's did around 6% to 7%. (Figures can vary depending on which fund or index you look at, what period of time, whether derivatives were used, etc.) GNMA investors were effectively LOSING money during one of the greatest bond bull markets. One major GNMA fund stated that their $7+ share remained stable during this interest rate drop. Stable? A completely misleading comment to an uneducated audience since it LOST money as compared to other bonds.
So what happens if interest rates should rise? Well, regular bonds lose in value given this example. Assume you have a $1,000 bond earning 6%. But rates over the next three years increase to 12%. Would someone pay you more or less than $1,000 for your bond earning half as much? Obviously less, and your bond is discounted. The duration might change to slightly longer since none of the bonds will probably be called. Is that the same thing with GNMA's? NO! Duration may go up considerably. Consider a homeowner having a 8% mortgage and interest rates increase to 12%. Would you refinance? No- you would probably only get rid of your loan if you had to move. And you might think twice about moving if rates were very high or going higher.
Here are statistics from the same WSJ article addressed above covering rates going up or down. "If rates rose by 1%, refinancing would drop and push the overall maturity to 17.67 years. If rates rose 2%, maturities would extend to 19.23 year. But if rates should fall 1%, many people start to refinance and the maturity would fall to 2.77 years. A 2% drop moves the maturity to just 1.10 years." But this comment still doesn't address the price volatility- which is can be greater than the movement of maturity.
Didn't understand all that? Well neither does your broker, the attorneys in arbitration or just about anyone else. But it is how they can work- though you can have numerous variations, particularly where derivatives are involved. At that point however, it may be impossible for anyone to figure out. Government Mortgage Passthrough Securities are NOT conservative because you have little idea of how the price will truly react given a movement in rates. The infinite calls and the uncertainty of the homeowner make it impossible. The past history shows that they do not move in the same manner as other bonds and the returns are far less. Lastly a portfolio manager of GNMA's said, "to be a passive investor in mortgages is a recipe for under performance."
Good Luck in using GNMA's. I won't use them because they don't react conventionally to price movement. I also think the risk/reward relationship is far too high. And if I can't reasonably understand/determine what will happen with an investment, then it makes little sense in using it.