Q. Would you discuss the risks involved in Fannie Mae and Ginnie Mae bonds and funds as to the interest rate risks and refinance risks?

---M.B., by e-mail from Arlington, TX


A. The ideal market for mortgage backed securities is one in which interest rates are relatively stable. In such a market, the investor won't be assaulted with refinancings. The investor will also collect the slightly higher coupon return offered by mortgage-backed securities.

Here's how it works. When you take out a 30-year home mortgage, you pay a long-term interest rate, currently averaging about 5.30 percent. That rate is about the same as the yield on a U.S. Treasury bond of similar maturity, recently 5.35 percent. The difference is that the average mortgage is paid off or refinanced long before 30 years have passed. In effect, the investor is receiving long-term rates for short-term money.

One measure of this is the average effective maturity of major GNMA mutual funds. While home mortgages are typically written for 30 years, the average effective maturity of the Vanguard GNMA fund is only 4.7 years. If you invested in a 5 year Treasury, it would yield only 3.65 percent. The Vanguard GNMA fund, however, was recently yielding 4.57 percent. That's one of the reasons I've mentioned this fund in my column.

Is there a catch?

Always. If you want to make a capital gain on your fixed income investments, mortgage backed securities aren't the way to do it. When you own a conventional bond, you know its maturity. You will collect its coupon yield for the life of the bond. There is no such certainty with mortgage-backed securities. In fact, they work perversely. If interest rates go down--- which would give you a capital gain as a bondholder--- your mortgage will be refinanced away so you'll never make the gain. If interest rates rise--- which would give you a capital loss as a bondholder--- the effect will be even worse. Instead of lasting 5 or 6 years, it may last 30. You'll be stuck with a low yield for the increasing life of the mortgage.

Worse, some GNMA funds sweeten their current yield by paying a premium for high coupon mortgage securities. That allows them to distribute an artificially high interest rate. What they don't tell you is that your principal is being reduced because they lose the premium they paid when the mortgages are refinanced at par value.

Fortunately, there is a way to avoid this. If you are offered a GNMA fund with an unusually high current yield, it's probably got a portfolio full of premium priced mortgage securities. Recently, for instance, Van Kampen U.S. Mortgage A shares was distributing at a 5.39 percent annual rate. At the same time the 30-day SEC yield on the fund was only 2.73 percent, reflecting the amortization of premiums paid. Van Kampen U.S. Mortgage has followed this policy for years. As a consequence, the total return of the fund has been lower than funds that don't have such a policy.

Vanguard GNMA, for instance, was distributing at a much lower 4.67 percent rate, very close to its 30 day SEC yield of 4.57 percent.


Q. We have about $60,000 in the Vanguard GNMA fund and are adding $1,000 a month through automatic investment. This is a cash reserve fund for us and so must remain relatively liquid. I recently requested a prospectus from the Vanguard Inflation Protected Securities mutual fund. Would you please contrast the pros and cons of each in a rising interest rate environment, keeping in mind our short-term purpose?

---J.Y., by e-mail, from Arlington, TX


A. What distinguishes the well-managed GNMA funds from regular bond funds is that they offer a higher yield relative to their effective maturity. Vanguard GNMA fund, with nearly $19 billion in assets, is the largest of the intermediate maturity government bond funds. It has performed in the top 17, 13, 15, 6, and 3 percentile of its intermediate maturity class over the last 12 months, 3 years, 5 years, 10 years, and 15 years, respectively. So it is a good choice for people trying to get a better yield on money they may need to access. Over the last 5 years, for instance, it has provided an annualized return of 6.81 percent

It is possible, however, to lose money in a GNMA fund--- even one as good as Vanguard GNMA. In 1994, one of the worst years for fixed income investing in history, the fund lost 0.95 percent. In 2003, a year of mortgage anxiety, the fund returned only 2.49 percent. In both years it was still in the top 25 percent of its category.

Vanguard Inflation Protected Securities fund (ticker: VIPSX) has provided a higher total return over the last 12 months and 3 years (7.28 and 9.83 percent, respectively, compared to 4.16 and 5.03 percent for Vanguard GNMA). Those impressive return figures should not be regarded as sustainable. The investment community was skeptical about the first offerings of Treasury Inflation Protected Securities. As a consequence, they had to be priced at a 3.5 percent premium to inflation. Today investors understand the bonds so the premium has been substantially reduced. As a consequence, future returns are likely to be more modest.

Neither fund is an ideal choice as a cash reserve. Of the two, the GNMA fund will probably serve you better.