Ginnies are reliable, but you need to diversify

Question: I don't want anything to do with the stock market anymore, and I can't see putting money in CDs. The rates are so low. I've had money in a Ginnie Mae fund. Can I continue to count on it?

Answer: There has been a lot of chatter about the stock market being risky. But now is the time to pay attention to risks in bonds, too, including Ginnie Maes.

At first, you could conclude there is no risk in Ginnie Mae bonds. The bonds are created out of mortgages. The mortgages from many homeowners are pooled, and bond investors are paid as homeowners make their payments.

Because the government guarantees that the interest and principal will be paid on Ginnie Maes, there is virtually no risk, even though many people cannot pay their mortgages.

"After Treasuries, Ginnies are the next safest," said Daniel Hall, a principal in portfolio review for the Vanguard Group Inc.

But with bonds - whether Ginnie Maes, Treasuries, municipal bonds, or corporate bonds - there is another way to lose money: If interest rates start to climb, you can lose money on the bonds.

Recently, Ginnie Maes have been yielding more than 4 percent. Meanwhile, many CDs are paying 2 percent or more, and 10-year Treasuries are more than 3 percent.

But this is an unusual period. The likelihood of interest rates staying at these low levels is remote. So when investors can earn more on bonds, they are not going to want low-interest individual bonds or the low-interest bonds in your Ginnie Mae bond fund.

Consider when CDs and Treasuries start paying 6 percent or more, as they have in the past. Your Ginnie Maes yielding 4 percent will not look as good to you. And they will not look good to other investors.

So the value of your Ginnie Maes could fall. If you hold on to them until they mature, you will not lose money, but you will settle for the low interest assigned to them. But if they are in a Ginnie Mae fund, the value of your fund will likely fall because the fund will be loaded with low-interest bonds when investors can find other, higher-interest bonds.

Hall notes that, in 1994, as rates climbed sharply, the total return on Ginnie Maes declined 0.95 percent.

If this happens again, your bond fund will not be a loser forever, because the fund manager will start buying higher-interest bonds. But if you have been using a Ginnie Mae fund like a savings account, and need the money when values are down, you could take a loss.

This does not mean to avoid Ginnie Maes completely. They are often considered a solid part of a diversified bond portfolio. But do not put all your cash into a Ginnie Mae fund if you plan to use it for living expenses over the next couple of years.

"Some people view these as a money market substitute, and they aren't," Hall said.

There also is "prepayment risk." Recently, people have had difficulty refinancing mortgages.

But a big risk to Ginnie Mae investors normally is the risk that interest rates will fall and people will refinance their mortgages. When this happens, investors receive their money back and have to reinvest it at a time when interest rates are low.

Because of this risk, investors in Ginnie Maes typically earn higher interest than they do on U.S. Treasuries.

But realize that when you see a rate higher than on another bond, it is to entice you to take more risk. And realize that the government is playing a huge role in propping up the mortgage market by buying and guaranteeing mortgages. Eventually, it will do less, and, Hall said, that could affect the value of mortgage-related securities as investors react to the new environment.

Gail MarksJarvis is a personal-finance columnist for the Chicago Tribune. E-mail at gmarksjarvis@tribune.com.