Low Mortgage Rates Hurt GNMA Bonds

Investors in GNMA mortgage bonds have seen their securities slammed over the past two days, even as Treasury and corporate bond values have zoomed with the slide in market interest rates.

Worse, the GNMA market’s troubles may only be beginning, thanks to a tidal wave of mortgage refinancings expected this fall. If you own these bonds--or mutual funds that hold them--it’s time to decide if you still belong.

Thursday, a Merrill Lynch & Co. index of GNMA bond prices slumped 1%. While other categories of bonds also lost ground after the sensational rally early in the week, most of the day’s losses amounted to less than half what GNMAs lost.

If you own a GNMA mutual fund, today’s fund listings in The Times probably show that your fund dropped in value.

GNMA stands for Government National Mortgage Assn., a federal agency under whose authority mortgages on individual homes are packaged and sold to investors in the form of bonds. The bondholders get the loan interest paid by the homeowners; it’s simply passed through to the investors as the homeowners make their monthly payments.

The concept is sound and has worked well since the 1970s. In fact, GNMA mutual funds now hold $45 billion in assets, the second-largest category of taxable bond funds after U.S. Treasury funds.

But GNMAs have one big flaw: When market interest rates dive, homeowners rush to refinance their mortgages at lower rates.

That means GNMA bondholders who had counted on earning, say, 9% on a bond for seven years may suddenly find that they’ll get their money back much earlier--forcing them to reinvest it at a much lower rate. Basically, GNMA lets homeowners take advantage of any decline in interest rates by refinancing without penalty. The bondholders have to live with that risk.

With the sharp drop in mortgage rates over the past few weeks to the lowest levels since 1973, homeowners are flocking to refinance. The Washington-based Mortgage Bankers Assn. on Thursday reported that its index of refinancing activity has soared to 1,410.7, up from 400.0 in May. That means refinancings are running more than triple the pace of May.

Faced with that evidence, many GNMA owners on Wall Street bailed out over the past two days, selling their GNMA bonds and using the proceeds to lock in yields on Treasury bonds--which don’t have the premature-payment risk of GNMAs.

“They’re selling GNMAs into any bid they can find out there,� says Jim Hodapp, a government securities trader at brokerage A. G. Edwards & Sons in St. Louis. The panic selling has sent the value of GNMA bonds plummeting.

What’s more, for two main reasons many experts don’t believe the GNMA selloff is over:

* Investors who expect long-term interest rates to head lower for the duration of the year--and possibly through 1993--are rushing to buy Treasury and corporate bonds maturing in 10 years or longer, to snag those yields before they disappear.

By contrast, even when refinancings aren’t booming the average maturity of GNMA bonds is five to seven years. Bonds of those terms are least in demand right now.

* The wave of mortgage refinancings will mean that a slew of new, lower-yielding GNMA bonds will hit the market this fall, notes bond trader Maureen Marren at Mabon Securities in New York. Whenever any segment of the bond market faces ballooning new supply, existing bonds in that segment can drop in value--no different than any other commodity in oversupply.

GNMA bond fund managers admit that their market faces problems in the near term. But many also argue that the drop in GNMA bond prices has already driven yields on the bonds to extremely attractive levels.

In general, GNMA bonds now yield one full percentage point more than Treasury bonds of similar maturities. Many GNMA mutual funds yield 7.5% or better, versus a 6.2% yield on seven-year Treasury notes.

But bond experts note that the higher the yield on a GNMA fund, the greater the risk that the yield will fall drastically as mortgage financings rocket. Why? By definition, the funds that yield the most own the highest-rate mortgages. Those mortgages are likely to be the first to be refinanced this summer and fall.

Paul Sullivan, manager of the Vanguard GNMA fund in Valley Forge, Pa., estimates that 50% of the $350-billion GNMA securities market is made up of mortgages that cost homeowners 9% to 10% interest. With long-term mortgage rates now below 8% in some parts of the country, that 50% chunk of the GNMA market is ripe for refinancing, Sullivan says.

The best advice for GNMA bond or bond-fund owners? If GNMAs are the only type of bond you own, it’s time to diversify. If high income is your goal, shovel some of your GNMA assets into bond funds that own Treasury bonds or corporate bonds. They may not yield quite as much as GNMA bonds, but the coming refinancing wave tells you that those current GNMA yields are illusory anyway.

In addition, if you believe that long-term interest rates are indeed headed south, existing fixed-rate Treasury and corporate bonds will appreciate in value. But another drop in market rates would just cheapen GNMA bonds further by boosting mortgage refinancing expectations.

Jack Lemein, manager of the San Mateo-based Franklin U.S. Government Securities fund--at $13.5 billion, the nation’s biggest GNMA fund--says he isn’t selling into the panic. But he also admits he isn’t buying yet. “For the past few days I’ve just sat on my hands,� he says.

For many GNMA bond owners, there’s no harm keeping some share of your assets in those bonds. This isn’t the end of the world, after all. But it’s important to understand that every type of bond has good and bad cycles. For GNMA bonds, the bad part of the cycle may be at hand.

GNMA Funds Slide

How some of the biggest mutual funds that invest in Government National Mortgage Assn. bonds have dropped in value over the past week.

Net asset value per share: GNMA fund Last week Thurs. Change AARP GNMA $16.17 $16.04 -$0.13 Fidelity GNMA $11.14 $11.06 -$0.08 Fidelity Spartan GNMA $10.51 $10.41 -$0.10 Franklin U.S. Govt. $7.25 $7.20 -$0.05 Kemper U.S. Govt. $9.52 $9.51 -$0.01 Scudder GNMA $15.61 $15.50 -$0.11 T. Rowe Price GNMA $9.97 $9.91 -$0.06 Vanguard GNMA $10.53 $10.40 -$0.13