Q. I am retired, invest for income, and have most of my money in the Vanguard GNMA fund. This has worked out well in the past and has provided a reasonably good steady income. I can maintain my lifestyle as long as the fund continues to provide capital and income returns that fluctuated within the historical norms. I sense unusual, if not unprecedented changes or potential changes in the mortgage sector and have difficulty understanding the possible effects on GNMA funds.

Although usually not a sector timer, I am considering a fund switch to preserve capital and reinvest after things settle down. Could you comment on this and factors that influence changes in GNMA funds?

---P.K., by e-mail

  

A. Mortgage security funds like Vanguard GNMA buy government guaranteed securities representing pools of mortgages. They are very different from normal bonds because a conventional bond has a fixed date of maturity. Whether you buy a normal bond at issue or in the after-market, you will always be able to calculate your yield to maturity because you know the price, the maturity, and the amount of interest you will collect.

Mortgage securities are a completely different animal because consumers have the right to sell or refinance their homes at any time. As a result, the "maturity" of a mortgage security is highly uncertain. If the economy is good or interest rates are falling, people will sell or refinance more often. This shortens the life of the security.   If the economy is bad or interest rates are rising, people tend to stay put and hold on to their lower interest rate mortgages. A shift in either direction will change the yield to maturity of the mortgage pool.

These shifts aren't minor events. If a portfolio manager loads up a portfolio with older, higher yield mortgage securities he will pay a premium over par. The good news is that a high interest rate will be received. The bad news is that the mortgages will be pre-paid quickly and they will be prepaid at par--- so any premium over par will be lost. Recently, for instance, 7.5 percent GNMA securities were priced at 106.5 but had an average life of 1.4 years. With the premium over par vaporizing, the true expected yield to maturity was less than 3 percent.

Your fund, Vanguard GNMA, has been a top performer for years. It lost money in only one year, 1994. That was when interest rates soared and bond funds had their worst year in history. The fund lost 0.95 percent--- but its performance was in the top 6 percent of funds in its category.

In 1987, another year of rising interest rates, the fund had a return of only 2.15 percent and ranked in the 46th percentile. Over the last ten years it has provided an annualized return of 7.17 percent according to Morningstar, beating more than 90 percent of its competitors. I think it is fair to say that when interest rates rise, this mortgage security fund has been a pretty good place to have your money.

In 1993 interest rates dropped rapidly and we had a major mortgage-refinancing boom. Vanguard GNMA fund returned only 5.9 percent and ranked in the 87th percentile. This was the only bottom quartile performance in the funds' history. This year, in another refinancing boom, the fund has been in the top 30 percent year to date and in the top 8 percent for the preceding 12 months. They must have learned something in 1987.

GNMA funds provide their best returns when interest rates fluctuate within a narrow range. When that happens you get their higher yield relative to Treasury securities and no principal value change. Today, we are facing a decline in mortgage rates that has caused a gold rush in refinancings. We also have a growing market in a new type of mortgage--- low rate interest-only adjustable mortgages. Merrill Lynch, for instance, is currently offering such monthly adjustable mortgages with an APR of 3.967 percent.

These are the reasons my column has urged investors to consider funds that specialize in adjustable rate mortgages as well as Vanguard GNMA.

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