The Effect of the Interest Rate Increase on GNMA Bond Funds

Ginnie Mae funds provide government-guaranteed bond income.
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You might like the idea behind Government National Mortgage Association — Ginnie Mae, or GNMA — bond funds: Earn government-guaranteed interest with a higher rate than Treasury bond interest. This feature makes Ginnie Mae funds a good choice for income investing. If you own a Ginnie Mae fund, though, one thing you won't like is the negative short-term effects of rising interest rates. But your fund yield will eventually catch up with the higher rates.

Who Is Ginnie Mae?

GNMA promotes home ownership by guaranteeing the payment of principal and interest on home loans made through the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA). FHA and VA loans are gathered into pools of similar mortgages, and the pools provide the cash flow to back Ginnie Mae mortgage-backed securities. Ginnie Mae does not issue or sell mortgage securities. The agency just provides the guarantee for the mortgages backing a Ginnie Mae bond.

Ginnie Mae Fund Function

A Ginnie Mae fund is a bond fund that holds a portfolio of Ginnie Mae mortgage-backed security bonds. As the Ginnie Mae bonds owned by the fund make monthly payments, the bond fund passes the interest to fund investors in the form of monthly dividends. Ginnie Mae bonds are marketable securities, so the share price of a Ginnie Mae fund fluctuates with changing bond prices. The payments from a Ginnie Mae bond reflect the mortgages backing the bonds and consist of both interest and return of principal. A bond fund strips out the principal amounts to reinvest in more Ginnie Mae bonds, and passes the interest to investors.

Ginnie Mae Yields

Although the interest on a Ginnie Mae bond comes from a pool of mortgages all paying the same rate, the yield on one of these bonds may be significantly different. The bond market will adjust the price of Ginnie Mae bonds so that the yield is typically 0.5 percent to 1 percent higher than Treasury bonds with similar maturities. So, over time, a Ginnie Mae bond fund will yield a similar spread over a comparable Treasury bond fund.

Rising Rates, Falling Prices

A basic fact of bond investments is that rising interest rates result in falling bond prices. In a rising rate environment, the prices of Ginnie Mae bonds and the share prices of Ginnie Mae funds decline. The "average duration" figure published by a bond fund tells you how much the fund's share price will change with a 1-percent change in interest rates. For example, one large GNMA fund quotes a current duration of 3.2 years. This means a 1-percent increase in market interest rates will result in a 3.2-percent drop in the fund's share price.

Eventual Higher Dividends

The portfolio of a GNMA fund is not static. The fund receives principal payments from the bonds and new investor money, and the management can buy and sell bonds to find better values. Falling share prices result in a higher current yield, but this fact is of little comfort to investors who have seen their account values decline. As a Ginnie Mae fund is able to purchase new bonds with higher yields, the dividend payments will slowly start to increase, resulting in higher income for investors. However, the increase in dividend payments will happen at a much slower pace than the decline in share prices when rates increase.

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