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Fund Family Shareholder Association
www.adviseronline.comMortgage Association (or GNMA) is
a government entity, so its mortgage-
backed bonds carry an explicit guaran-
tee from the U.S. Government—like a
Treasury bond. Fannie Mae (FNMA)
and Freddie Mac (FHLMC) are gov-
ernment-sponsored entities that also
create and sell mortgage-backed bonds.
Because of their quasi-relationship with
the government, many investors view
their securities as being backed by
a government guarantee, though the
assurance is not as strong as with
GNMAs.
Mortgage-backed bonds, however,
are subject to what’s called “prepay-
ment risk,” which is an exaggerated
form of reinvestment risk. Remember
that reinvestment risk, as we discussed
in the August issue, is the possibility
that just as your bond is maturing and
you have all your principal to reinvest
in a new bond, the options available are
paying lower yields.
Well, prepayment risk derives from
the ability of borrowers to repay their
mortgages early. If interest rates fall,
homeowners may refinance, and when
that happens, the mortgage underly-
ing a portion of the GNMA bond dis-
appears, as the principal is returned.
So when interest rates fall, investors
in GNMAs typically begin receiving
prepayments, which they then have to
reinvest at lower yields. When inter-
est rates rise, homeowners tend not to
refinance, so the underlying mortgages
stay put, and investors get less money
back to reinvest at higher rates—a true
double-edged sword that can nick you
either way.
Prepayment risk sounds like a tough
deal for GNMA investors, and for the
unaware, it certainly is a risk—and
justification for GNMAs yielding more
than Treasurys. Prepayment risk is just
one reason I prefer the actively man-
aged
GNMA
over
Mortgage-Backed
Securities ETF
. GNMA manager
Mike Garrett of Wellington is well
aware of the aforementioned risks and
focuses on bonds whose underlying
mortgages are “seasoned,” or less likely
to be repaid early.
Combining mortgage-backed secu-
rities from Fannie Mae (FNMA) and
Freddie Mac (FHLMC) as well as
GNMAs, the Barclays U.S. Mortgage
Backed Securities index that Mortgage-
Backed Securities ETF is designed to
track is wider-ranging compared to the
mandate of its actively managed sib-
ling. The fund holds nearly 500 bonds.
How about GNMA? Michael Garrett
holds just 35 bonds.
This narrower focus hasn’t held back
Garrett versus his in-house index compe-
tition. Since the ETF began operations in
November 2009, GNMA outperformed
21.9% to 18.7%. We can take this back
further, as the performance history for
Mortgage-Backed Security ETF’s index
stretches to 1991. Again, GNMA out-
performed, and this is before applying
any kind of operating expense headwind
to the 18 years or so of the index’s
returns prior to the ETF’s launch.
With a yield of only 1.52%, the ETF
is well behind GNMA’s 2.22% yield.
That’s another reason why I give the
nod to the active fund.
High-Yield Corporate
Buy.
High-Yield Corporate
is a “junk
bond” fund and as such is a very differ-
ent animal from all of Vanguard’s other
bond funds.
The bonds in this fund are issued by
companies with less-than-stellar credit
ratings. To attract investors, they must
offer higher yields, since the pros-
pect of default is higher. And when it
comes to yield, what a difference a year
can make. In June 2014, High-Yield
Corporate’s yield reached a record-
low 3.85%—not exactly living up to
its “high yield” name. But with falling
oil prices putting pressure on energy
companies, which tend to be big issuers
of junk debt, yields in the high-yield
market have risen as investors, trying
to avoid troubles in one sector, sold
across the entire high-yield market.
High-Yield Corporate’s current 5.60%
yield is looking a lot nicer today, and
means we are picking up 4.16% (or
416 basis points) over Intermediate-
Term Treasury’s 1.44% yield and 283
basis points over Intermediate-Term
Investment-Grade’s 2.77% yield.
Importantly, High-Yield Corporate
kicks off additional income without tak-
ing on more interest rate risk compared
to its higher-quality intermediate-term
siblings. Remember, as we discussed
last month, junk bonds move more in
line with the economy than with inter-
est rates. A growing economy makes it
easier for less financially stable compa-
nies to pay back their debts.
High-Yield Corporate isn’t the
screaming buy it was we bought
the fund for the
Model Portfolios
in
September 2011, but I continue to see
good relative value in this holding.
Extended DurationTreasury ETF
Sell.
Buckle up! When a bond fund can
gain or lose more than 20% in a month,
you know it’s volatile.
Extended
Duration Treasury ETF
has already
had four months in its relatively short
life when it moved 20% or more. The
fund’s duration of 24.7 years is much
longer than its long-term siblings. Yes,
you could buy this fund to bet on lower
interest rates or sell it if you think rates
are headed higher (and I suspect many
traders do just that). But, simply put,
this fund is just too volatile for investors,
and hence Vanguard doesn’t even offer
it in a low-minimum, open-end fund
format. You have to buy the ETF to play
this game. (Institutions with at least $5
million can, however, buy Vanguard’s
institutional open-end fund if they like.)
But why would you want to?
Total International Bond Index
Hold.
After years of resisting and several
delays, Vanguard succumbed to indus-
try and customer pressure and brought
an international bond fund to market in
May 2013. For all its initial hemming
and hawing, Vanguard itself has now
gone whole-hog into this fund, carving
out 30% of the bond allocation in its
funds-of-funds and 529 plans for
Total
International Bond
.
The fund tracks a mouthful of a
benchmark, the Barclays Global
Aggregate ex-U.S. Dollar Float-
Adjusted RIC Capped Index (Hedged),
which covers around 8,000 investment-
grade securities across the globe. As
you can see in the table on page 5,
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