GNMA bonds, also known as Ginnie Mae bonds, are fixed-income mortgage-backed securities (MBS) that are issued and guaranteed by the Government National Mortgage Association (GNMA). These bonds are backed by pools of mortgages that are insured or guaranteed by the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), or the Department of Agriculture's Rural Housing Service (RHS).
GNMA bonds are often attractive to income-oriented investors because they typically offer higher yields than U.S. Treasury securities. However, investors should be aware of the prepayment risk associated with these bonds, which can impact their returns if homeowners refinance their mortgages or sell their homes earlier than expected.
Credit & Refinance Risk
GNMA bonds are considered to be less risky than other mortgage-backed securities because they are backed by the full faith and credit of the U.S. government. The interest and principal payments on these bonds are guaranteed by the government, which means that investors are protected from credit risk.
Traditionally though, these bonds have been hampered by refinance risk. Refinance risk in bonds refers to the possibility that borrowers will refinance their debts, resulting in the bonds being paid off before their maturity date. This risk is particularly relevant for bonds backed by mortgage loans, such MBS’s.
If homeowners refinance their mortgages, the underlying loans are paid off, and the bondholders receive their principal back sooner than expected. As a result, the investor now faces the challenge of finding similarly high-yielding investments to replace the paid-off bonds. Refinance risk can impact the cash flows and returns of a bond portfolio and is an important consideration for fixed-income investors.
Investing in GNMA Bonds
Today we find GNMA bonds in a favorable position as prepayment risk is very low. Homeowners are disincentivized to refinance due to historically low mortgage rates in recent years, and a substantial drop in rates would be needed to bring back refinancing incentives. This means that a large source of prepayment risk has been eliminated.
The prepayment speed, measured by the conditional prepayment rate (CPR), is influenced by mortgage rates, and the last time rates were this high, the CPR was relatively high as well. In this case rates were falling, and homeowners were refinancing out of higher rate mortgages and into new lower rate ones.
While other factors such as migration, death, and foreclosure can still introduce prepayment risk, they are unrelated to interest rates, making prepayments just as likely in a high-rate environment, which is good for investors.
The current environment of elevated mortgage rates is different because borrowers are already paying low rates having refinanced or purchased previous when prevailing rates were much lower today. In this case the incentive to refinance is long gone.
Are they right for you?
If you’d like to learn more about how GNMA bonds may be right for you please don’t hesitate to reach out, firstname.lastname@example.org.
Bryant Trombly is a Wealth Advisor and Founding Partner of Destination Wealth Advisors where he works with his clients to make the most out of the current economic conditions while planning for complex and long-term goals. He has over 13 years of industry experience and lives and works in the beautiful Lake Norman area of North Carolina with his wife and two daughters and is originally from New England.