Ginnie Mae funds may be an option

Investors continue to place an unusually high premium on safety.

How else to explain the record low yields they're willing to accept for lending to Uncle Sam?

The rate on the 10-year Treasury note was recently down to 1.39 percent. That's paltry payback for locking up money for a decade.

Investors can earn significantly more by taking on just a bit more risk. Yields of mutual funds that specialize in government-backed mortgage bonds known as Ginnie Maes are currently more than double those of Treasurys maturing over a similar number of years. Several such funds are generating yields exceeding 3 percent.

These funds invest in pools of home mortgages that carry the explicit guarantee of the Government National Mortgage Association, or Ginnie Mae. Investors in Ginnie Mae bonds are ensured full and timely payment of principal and interest, regardless of whether borrowers make payments.

"If you're conservative, and looking for that steady diet of payments, Ginnie Mae funds can be a great option," says Jeff Tjornehoj, a bond-fund analyst with Lipper Inc.

It's decent income for risk-averse investors who may appreciate the monthly cash distributions they can elect to receive from their fund's investment returns.

Funds specializing in Ginnie Maes attracted more than $7 billion in new cash over the last 12 months, according to Lipper.

The 15 funds in the category, most bearing the abbreviation GNMA, have posted an average total return of 5 percent over the last 12 months. Returns have ranged as high as 7.1 percent for Payden GNMA (PYGWX) to as low as 3 percent. But the category's recent solid performance doesn't necessarily mean Ginnie Mae funds will be a good addition to any portfolio.

Some key considerations. Expect smoother returns than you'll get from higher-risk segments of the bond market. For example, in 2008, the Vanguard GNMA fund (VFIIX) returned 7 percent, as Ginnie Maes offered safety during the financial crisis. Compare that with the 2008 losses averaging 26 percent for funds specializing in high-yield corporate bonds.

Not all these funds are alike, however. They are required to invest at least 80 percent of fund assets in Ginnie Mae bonds. Still, managers have leeway with the other 20 percent. Non-GNMA mortgage investments can be found in their portfolios, as well as other government bonds, such as Treasurys. So returns can vary significantly from fund to fund.

Some funds with Government in their names but not GNMA invest in Ginnie Maes, as well, but don't focus on them. Although those funds' broader investment mandates can sometimes result in stronger returns, risks are typically lower at a fund that largely sticks with the agency's guaranteed bonds.  

Prepayment risk. One unique aspect of Ginnie Maes makes them slightly riskier than other government-guaranteed bonds. Declining interest rates means many homeowners are trying to refinance to less expensive mortgages, creating "prepayment risk" for Ginnie Mae funds.

When refinancing activity spikes, some of the higher-rate mortgages in Ginnie Mae funds are replaced by lower-rate mortgages. That squeezes the interest payments a fund's bond portfolio earns, and fund returns can be reduced.

Rate risk, too. Just like those owning other types of bonds, Ginnie Mae investors could see returns shrink if interest rates rise. Market values for mortgage investments bought when rates were lower would drop as investors seek higher returns from newer mortgages paying higher rates.

Investors wishing to protect against this risk should check disclosures listing a fund's duration, a measure of vulnerability to rising rates. Most Ginnie Mae funds currently have durations of 2.5 to 4.5. The bigger the number, the more risk an investor faces from a potential rate increase.

But that risk isn't imminent. The Federal Reserve doesn't expect to raise its benchmark rate until late 2014, at the earliest.