Good Mortgage Bonds

When you lend money to Uncle Sam, you know he'll pay you back. However, the government must plug huge holes in its budget through massive borrowing, and that will inevitably undermine the value of its long-term Treasury bonds. So you face an unpleasant choice: Buy Treasuries, which yield little and could depreciate significantly in the future, or aim formore yield now by taking your money to some of the edgier neighborhoods of the bond market, such as junk bonds and emerging-markets bonds.

But most of us just want a safe investment that pays more than the 3.3% that ten-year Treasuries pay now, or the 3.1% you get from the average five-year CD. Those yields are so paltry you might as well feed an online savings account paying less than 2% while you wait for the economy to recover and interest rates to rise.

The Ginnie alternative

There is, however, an often-overlooked option that is safe and pays more than Treasuries. I'm referring to Ginnie Maes, or mortgage securities guaranteed by the Government National Mortgage Association.

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Before you think I've lost my marbles recommending investing in home loans less than a year after mortgage derivatives nearly incinerated the nation's financial system, let me explain. The Ginnie Mae brand is different. Ginnie Mae isn't a company whose executives' overarching goal is to boost the share price; it is an agency within the U.S. Department of Housing and Urban Development that simply stamps Uncle Sam's full faith and credit on pools of conservative, privately issued home loans. Ginnie doesn't mess with exotic mortgages. It mostly guarantees securities that are insured by the likes of the Department of Veterans Affairs and the Federal Housing Administration.

During the financial meltdown, Ginnie Mae securities stood tall. From September 10 through May 8, Vanguard GNMA (symbol VFIIX), the largest mortgage mutual fund, returned 5.1%, three percentage points better than the Barclays Capital U.S. Aggregate Bond index, which tracks the broad bond market. BlackRock GNMA (BGPAX), Fidelity Ginnie Mae (FGMNX) and Payden GNMA (PYGNX) did even better. American Century Ginnie Mae (BGNMX) virtually equaled Vanguard. Dreyfus GNMA (GPGAX), which can put up to 20% of its assets in credit-card receivables and mortgage securities that aren't guaranteed, lagged. But even it gained 4% in those eight months.

GNMA funds got some help from the red tape and scarcity of credit that's made it hard for homeowners to refinance mortgages. Refis, which replace higher-paying loans with lower-paying ones, are a headache for investors in mortgage pools. Because of refis, Treasury bonds usually do better than Ginnies when interest rates fall.

But Ginnies typically outpace Treasuries when rates go up. Although rising rates will erode some principal, they also make it more likely that older, higher-paying mortgages will remain in the mortgage securities that you or your fund owns. And because Ginnies yield more than Treasuries, their prices will probably fall less when rates rise.

You need $25,000 to buy a single Ginnie. Throw in the complexity of mortgage securities, and this is one area of the bond market in which it often makes more sense to invest in funds rather than individual issues. Besides, funds normally hold some older, higher-rate pools, which can serve as a buffer when yields rise.

I asked a broker for some current quotes on individual GNMA securities. Although the yield spread between Ginnies and Treasuries has narrowed of late, mortgages still pay more. A GNMA pool issued in April was priced to yield about 3.9% on the assumption that half of the loans would be turned over in six and a half years. That's a scant return if you have to worry about heavy defaults. But it's not bad considering Ginnie has Uncle Sam's full faith and credit at her back.

Jeff Kosnett is a senior editor at Kiplinger's Personal Finance.