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Thursday, February 12, 2009

Vanguard's GNMA versus Total Bond Fund

Vanguard has two excellent funds called "Vanguard GNMA Fund" (VFIIX Charts) and "Vanguard Total Bond Market Index Fund" (VBMFX Charts). VFIIX invests mostly in Government National Mortgage Association (”Ginnie Mae”) securities. These securities are backed by the U.S. government so they get the top Aaa rating at Moody's and AAA at Standard & Poor's. Much more diversified VBMFX invests in more than 3,000 bonds representative of the broad, U.S. investment-grade market. Investment grade means ratings are Aaa to Baa3 at Modie's and AAA to BBB- at S&P.

Both are "Investor Class Shares" which have the lowest minimum required investment of $3,000. Bob Brinker recommends the GNMA Fund on his radio show, Moneytalk (See Bob Brinker's Current GNMA Fund Advice), but Brinker seldom talks about the Total Bond fund that is preferred by most followers of modern portfolio theory (mpt) and fans of diversification.

Performance Comparison between VFIIX and VBMFX:
3 yr annual return: VFIIX=6.04%; VBMFX=5.28%
3 yr annual SD: VFIIX=3.36%; VBMFX=4.11%
10 yr annual return: VFIIX=5.68%; VBMFX= 5.68%
(per Morningstar)
where "SD" is standard deviation, a measure of volatility.

Fixed income characteristics as of 12/31/2008:

GNMA Fund Investor Shares
Yield to maturity = 3.4%
Average coupon = 5.6%
Average maturity* = 1.7 years
Average quality Aaa
Average duration** 1.0 years
Total Bond Market Index Fund Investor Shares
Yield to maturity = 4.0%
Average coupon = 5.3%
Average maturity* = 5.4years
Average quality** = AA1/AA2
Average duration*** = 3.7 years
*Yield to maturity is the rate of return an investor would receive if a security is held to its maturity date.

**Average Quality: Aaa is Moody's highest ranking. AA1 and AA2 are the next two lower ratings for high grade bonds. See Bond Ranking Table at Wikipedia.

***Duration is a measure of the sensitivity of bond—and bond mutual fund—prices to interest rate movements. For example, if a bond has a duration of two years, its price would fall about 2% when interest rates rose one percentage point. On the other hand, the bond's price would rise by about 2% when interest rates fell by one percentage point.

The total bond fund is an index fund while the GNMA fund is not. The fund manager for the GNMA fund will adjust the fund holdings to affect duration and yield to anticipate the future direction of interest rates. This is market timing.

I own some of both funds.

For the "explore" or "mad money" part of my "core and explore portfolio," I use the GNMA fund to buy when its NAV is low due to exuberance (low fear) for stocks that drives interest rates up (and NAVs down) as money flows from fixed income to equities. If I am wrong with my "attempt" to time bonds, then I have a good fund with great yield and 100% backing by the government's ability to print money. If I am right with my timing, the fund can sometimes give more bang for the buck than Total Bond for short term moves since the fund manager adjusts duration.

The GNMA fund manager now has duration very short so I've taken profits to wait for the next low NAV time to repurchase. I'll buy the shares back when duration is longer and rates are higher, perhaps when people are euphoric about stocks again which causes money to flow from safe bonds to risky stocks.

For the core part of your portfolio, I recommend Total Bond (VBMFX) for those who want to keep it simple.

If you want "rebalance premium" from the inflation and deflation cycles, then I prefer splitting the money into TIPS, Cash/CDs/MM Funds and Total Bond to some allocation you are comfortable with THEN rebalance back to that target allocation whenever the allocation gets a set percentage out of balance.

That is keep the total bond fund in your core portfolio and use the managed GNMA fund in your explore portfolio.

The knock on GNMAs for the long term is they are essentially "callable" in that people tend to refinance when rates drop so you don't get the same NAV upside potential from falling rates. This has not been a problem the past 10 years as rates for mortgages have not fallen nearly as much as Treasury rates... On the flip-side, when rates go up, people tend to not refinance... so you don't have a symmetrical risk/reward profile.

More charts for Vanguard Fixed Income Funds:
January 2010 Update: Last year I sold ALL my bond funds that are not indexed to inflation for my personal account. To see what I recommend these days, you need to subscribe to one of my newsletters. For details, see Kirk's Two Investment Letters

Kirk Lindstrom's Investment Letter Performance

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