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Ginnie Maes: Time to Give 'Em a Rest

Q: I invested in a Ginnie Mae fund a year ago and did very well. What can I expect from the fund in a falling interest rate environment? How will the interest payout be affected? - B.G., Massachussetts

A: You're right in thinking that the Federal Reserve's recent rate-cutting binge could pack an especially hard wallop when it comes to your Ginnie Mae fund. While changes in interest rates affect all fixed-income investments, mortgage-backed securities (MBS) like

Ginnie Mae pass-through certificates, are more sensitive than most. When interest rates are stable or rising, Ginnie Maes usually offer a higher yield than

Treasuries of the same maturity, but when rates drop, Ginnie Maes will generally do worse than Treasuries.

Why? Because Ginnie Maes can pay off early, leaving the investor with a lump of cash he or she has to reinvest -- at a lower interest rate. So long as Fed Chairman Alan Greenspan is in hacking mode, and all indications are that he will cut rates again toward the end of March, you may want to think about moving your money from a Ginnie Mae fund to a medium-term Treasury fund. It has the same

credit risk, but in a falling rate environment, you'll get more bang for your buck from the capital appreciation on Treasuries than you will on Ginnie Maes.

PREPAYMENT PENALTY. When you buy a Ginnie Mae certificate, you are buying the right to a stream of cash flow that comes from homeowners paying off the mortgages they got from the Federal Housing Administration (FHA). Ginnie Mae buys up a specific pool of FHA mortgages and pledges them to pay off a particular bond issue. The potential for early payoff of the underlying mortgages creates the risk in Ginnie Maes, and that generally leads investors to demand a higher yield than Treasuries -- even though they carry the same credit risk.

As all homeowners know, you can decide to pay off your mortgage at any time. As homeowners pay off the mortgages in the Ginnie Mae pool, then the MBS investor, whose bond is backed by those mortgages, is unexpectedly left with cash instead of a 15- or 30-year investment. Homeowners are more likely to prepay their existing mortgages when rates are falling, because they want to try to refinance at a lower rate.

If you own shares in a

Ginnie Mae fund, it will reinvest the cash windfall in another Ginnie Mae, but it is likely to have a lower yield if interest rates are dropping. So the yield on the fund will go down as well.

Since the prepayment risk is widely understood in the bond market, when interest rates fall, the price of Ginnie Maes does not go up as much as the price of Treasury bonds with similar maturities. Mortgage traders call this trait "negative convexity," one of those terms that financial pros like to brandish to baffle the rest of humanity. Of course, MBS traders incorporate some estimate of prepayments into their pricing models. When rates fall quickly, as they do when the Fed lowers the

discount rate, prepayments happen faster than most models have predicted.

The largest amount of refinancing ever took place in 1998, when the Fed dramatically lowered interest rates to contain the economic impact of the Asian financial crisis. In that year, the average medium-term Treasury fund outperformed the average Ginnie Mae fund. In 1999, rates were stable, and Ginnie Maes did better than Treasuries. In 2000, yields on Ginnie Maes would have topped Treasury yields except that the U.S. Treasury instituted a significant debt-buyback program. Scarcity of 30-year and 10-year bonds pushed up the price of the Treasuries remaining in the market.

"A STRANGE ANIMAL." Currently, Ginnie Maes yield about one perecentage point more than Treasuries with a similar maturity, according to Robert Young, director of mortgage research of Salomon Smith Barney. While the spread has widened over the last three months, it's still lower than it was between late 1998 and mid-2000, when so many homeowners refinanced their mortgages. The current spreads indicate that the market is pricing in stable interest rates for 2001. Such an environment should be good for Ginnie Maes, says Young. Since rates have already come down a lot, they could do very well by the end of the year, he adds.

"Over the long run, you'll do better in mortgages [than in Treasuries], but they're a strange animal -- you have to have a comfort level with them," Young says. "If you want to be conservative, put some money in mortgages and some in Treasuries. But mortgages offer potential additional yield."

With Greenspan & Co. likely to cut rates again in the coming weeks, Ginnie Maes are not likely to outperform Treasuries in the short run, but over the course of the year, who knows? It'll depend on how the Fed uses interest rates to manage the economic slowdown. Still, take heart in your fixed-income exposure. In the current bear market, investors in stocks would trade their paltry returns for a little "negative convexity" any day.

Do you ever get the feeling you could be doing something a lot smarter with your money? Do you know how to navigate the tricky currents of home-equity loans and mortgages? Ever worry about whether you've got the right insurance, or if your accountant is minimizing your tax bite as much as possible?

If you'd like the answers to these and other questions about your personal finances, shoot an e-mail to Ask, or send a letter to Ask Katie, Business Week Online, 6th Floor, 2 Penn Plaza, New York, NY 10121.

Please include your real name and phone number in case we need more information. If we use your question, only your initials and city will be given. Because of the volume of mail, we won't be able to respond to all questions personally. Questions may be edited for length and clarity. By Kathleen Turner Starr

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