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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

15 comments:

  1. Kirk, thanks for your thoughtful posted article on "Vanguard's GNMA versus Total Bond Fund".

    Here is something in particular you wrote Kirk that I think folks don't always think about, but it is extremely important.

    "I use the GNMA fund to buy when its NAV is low due to fear in stocks that drives interest rates down. 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."

    When you're right, you're a winner. And when you're wrong, you still win.

    Reminds me how great football teams sometimes play ugly, lose in all the stats, like first downs, time of possession, fumbles, interceptions, but still find a way to win the game.

    Sometimes even when we study and prepare, we're just flat out wrong about something.

    It's important to have a winning strategy so that when you're wrong, you still come out a winner.

    You gave a great example of a winning strategy Kirk.

    Thanks. ~ Ed

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  2. Both are good funds but the GNMA fund duration is a pure calculated number which gets shortened due to the high foreclosure rate. This could change dramatically.

    Since the Total Bond includes GNMAs, a portion of it also has a calculated duration.

    I also have some of each.

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  3. Hi Kirk:

    I also own some of both funds with Vanguard. You seem to know your stuff, so I have a question that nobody (my dad the financial planner, Yahoo Answers folk, and even the dude on the phone at Vanguard) has been able to answer for me, at least not to my satisfaction. My own research has not given the answer either. If you look back over time, 20 or 30 years, the price of the total market bond index (and I think, every other bond index at least those at Vanguard) has fluctuated around 10.00. Sometimes 9.50, sometimes 10.50, but never 6.00 and never 14.00, and it is clearly not headed to 30.00. I don't understand why it would be drawn to 10.00 all the time.

    I do understand that the monthly dividend is paid and maybe that is all there is to it. I don't think I care if it goes to 10.30 (even though the total value of my shares rises) because it is going back to 10.00 at some point. I don't care if it drops to 9.70 (even though the value of my shares decreases) because it is going back to 10.00 at some point.

    Obviously I have a long time horizon--20 years. This is the bond part (15%) of my retirement portfolio.

    Maybe the way to play it is to only buy new shares when the price is down (9.70, say), and either don't buy or even sell when they hit 10.30ish.

    What do you think?

    Thanks!

    John

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  4. Hi John

    Thanks for the kind words.

    Be careful what you conclude from limited data.

    The total bond fund at Vanguard was below $9 in 1989. See VBMFX Historical Chart.

    VBMFX might have gone lower had it been around earlier, but there is no data for it.

    If you look at the GNMA fund VFIIX Historical Chart that has a pretty close price-time relationship with VBMFX, you can see it was down below $7.50 back in late 1981 when inflation as very high (double digits!)

    As for my specific advice, in “Kirk’s Free Advice Portfolio” I like "120 less your age in equities" with the remainder in CDs or a low cost total bond fund such as Vanguard's total bond fund, (VBMFX). For the equity allocation, I like the total stock market index funds at Fidelity and Vanguard (VTSMX).

    If you want to try to beat the returns of “the market” made of “Kirk’s Free Advice Portfolio,” then up to 20% of your dollars in equities can be in your "explore" portfolio. For the explore part, anything goes but I ONLY give my specific “explore” advice in my newsletter. I also have a more complex core portfolio in my newsletter that allows you to take advantage of “rebalancing” for enhanced returns. See my article Using Asset Allocation to Make Money in a Flat Market. That method to get a “rebalancing premium” works to enhance returns in up and down markets but it is easiest to understand in a flat market.

    For example, if you calculate you should have $100,000 in equities by my formula, then you can allocate up to $20,000 to your own “explore portfolio.” For that explore portfolio, you can follow my explore portfolio percentage guidelines exactly or mix and match as you see fit.

    Only giving my "advice" in the context of my "explore portfolio" that requires a subscription is not as entertaining as Cramer's "Mad Money" but at least you can measure how the results work in the context of a total portfolio, not random noise.

    Click to SubscribeGood luck!

    ReplyDelete
  5. Hi Kirk:

    Thanks for the reply. I still don't get it. Even if over the long term the fund's price dips below 9 or even 8 in cases of extreme inflation or interest rates, and vice versa (above 11 or 12 when inflation and interest rates are really low), why does it always bounce back toward 10?

    It is because inflation and/or interest rates are also more or less range bound (zero on the low end, and 10% or 15% in extreme cases on the high end)? And so the bond fund prices fluctuate opposite the inflation/interest rates but are similiary more or less range bound? Not that there is a perfect relationship between them, but in terms of trends.

    So, I can expect inflation/interest rates to be somewhere between 0% and 15% when I need this money, and therefore can I expect the bond fund price to be between, say, 8 and 12 (probably between 9 and 11, etc.), and therefore I don't care if it goes up to 11 now or down to 9 because it is going to be close to 10 when I need the money?

    So, when it goes up to 11 and my fund holdings go up, I should not get excited...same on the downside...the only thing that seems to matter in this scenerio is my monthly dividend payment.

    Thanks again.

    John

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  6. This comment has been removed by the author.

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  7. Hi John
    .
    Lets say I started a mutual fund at $10 per share that bought 6-month CDs with FDIC insurance (See Very Best CD Rates) paying 2.3%, paid a dividend of 2.0% and charged 0.3% a year management fee. I would expect the Net Asset Value (NAV) of the fund to stay very close to $10 no matter what rates did.
    .
    Now lets say I started a mutual fund at $10 per share that bought 10 year junk bonds paying 6.5%, paid a dividend of 5.5% and charged 1.0% a year management fee. I would expect the NAV of that fund to go all over the map depending on interest rates and the market’s belief that the junk bonds will be repaid by the issuers.
    .
    Vanguard’s GNMA fund (VFIIX Historical Chart) falls somewhere between these two extremes with very little risk the US Government won’t back the bonds but quite a bit of interest rate fluctuation.
    .
    RE: So, I can expect inflation/interest rates to be somewhere between 0% and 15% when I need this money, and therefore can I expect the bond fund price to be between, say, 8 and 12 (probably between 9 and 11, etc.), and therefore I don't care if it goes up to 11 now or down to 9 because it is going to be close to 10 when I need the money?.
    No. If rates go to 15%, where the fund’s NAV goes would be a complex calculation but I’d sure care if the NAV fell to $9, $8, $7, $6 …. or lower. If it is at $7, you will have lost over 30% from where it is now less any interest you earned and kept. If you reinvested the interest, then that too will show a loss. I can’t believe you would not care about a 30% loss in something you thought was “safe.”
    .
    Click to Subscribe to Kirk Lindstrom’s Investment Newsletter.

    ReplyDelete
  8. Hi Kirk:

    I really appreciate your answers and your example REALLY helps. I am sure it is obvious to you, but when you said:

    "Lets say I started a mutual fund at $10 per share that bought 6-month CDs with FDIC insurance (See Very Best CD Rates) paying 2.3%, paid a dividend of 2.0% and charged 0.3% a year management fee. I would expect the Net Asset Value (NAV) of the fund to stay very close to $10 no matter what rates did."

    that kind of turned a light on for me...so as those CDs matured, if you bought subsequent CDs with interest rates of 3.3, 4.3, and 5.3 over the next 18 months, then you could raise your dividend to 3, 4, and 5 and consequently keep the NAV at 10, right?

    Certainly you are right that I would be getting a bit nervous if the NAV dropped to 8, 7, 6, etc. But, I still think that unless I needed the money right away (which certainly could happen, because when I get close to retirement MOST of my money will be in bonds, I assume), I would not be too worried....the interest rates rising to 15% that forced my NAV down to 6 will surely drop....maybe in a year, maybe in two years, maybe not for five years, but they won't stay at 15% forever. When they drop, up comes my NAV, right back toward 10. In fact, over the next 20 years or so, interest rates will probably trend up and down several times; my NAV will consequently go down and up several times as well. But it will keep passing 10, so as long as I sell it near 10, all I care about for the next 20 years is the size of my monthly dividend. Just like interest rates are "locked" between 0 and 20 (barring armageddon), my NAV is "locked" between 5 and 15.

    Right?

    Your example brought back memories for me too--my dad used to be a trust officer at a bank and told stories about the bank pushing long term bonds and getting HAMMERED when interest rates skyrocketed under Carter--after that he was purely into intermediate bonds for that reason.

    I feel guilty picking your brain so much...I am a statistician (but obviously not an econometrician), so if you ever need any help with more statistical stuff let me know (caruso@diss-stat.com).

    John

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  9. You bailed on Ginny too early. Today the fund is less than 1% from it's high. Returns are still great (2.06% YTD). You don't have to worry about defaults with Ginny because Uncle Sam owns a printing press. The fund is fully backed by the government just like treasuries. Over the past 5 years, the fund has returned 5.92% and over the past year it returned 6.65%.

    ReplyDelete
  10. "You bailed on Ginny too early. "

    Hardly. Last year GNMAs gained 5.29% and Vanguard's Tips fund, VISPX, gained 10.80%. I believe I sold the LAST of my GNMA fund to buy TIPS when GNMAs were up about 5% and the TIPS I bought then gained about 3% more. I'd say they have done fine.

    Also, even if GNMAs did better, I would not be upset because I think wanted to eliminate inflation risk. TIPS have the same guarantee as GNMAs or Treasuries PLUS they will increase payout if we get inflation while GNMAs and USTs will lose money. If inflation runs 2% a year, then the TIPS I bought WILL return their base rate (about 1.2% when I bought) plus the 2% inflation which is just fine. If we get more inflation, say 4%, then they will return 5% while GNMAs and USTs would probably lose money. I was more interested in capital preservation with moderate inflation than getting the last percent yield while inflation remains low.

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  11. I still think you bailed too early. GNMA prices are at (or very close to) and all time high.

    ReplyDelete
  12. "I still think you bailed too early. GNMA prices are at (or very close to) and all time high. "

    I don't agree. Remember much of my gains came last year in TIPS vs GNMAs .. Also, in my explore portfolio, I sold the last of my GNMAs last year at $10.72.

    * in 2009 Vanguard's TIPS fund, VIPSX, gained 10.8%
    * in 2009 Vanguard's GNMA fund, VFIIX, gained 5.3%

    For 2010 through the first half (6/30/10)
    Vanguard's TIPS fund, VIPSX, gained 4.28%
    Vanguard's GNMA fund, VFIIX, gained 5.43%
    This was for year over year inflation of only 2.0%. I expect inflation to be slightly to much higher on average over the next 10 years so I can "live" with under performing GNMAs by 1.15% SO FAR this year after beating them by 5.5% last year.

    Remember too that I have plenty of income from selling newsletters and people clicking ads on my web sites and blogs so I am mostly interested in capital preservation on the fixed side of my portfolio. I'm not looking for that last percentage point of income while playing musical chairs and hot potato with an eventual change of direction for interest rates. Someone who needs interest income to live on might think differently, but I think it is a mistake.

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  13. GNMA continues to set all time highs. At current price of $11.08, total 2010 YTD return is 6.41%. It just keeps getting worse and worse for you Kirk, doesn't it?

    ReplyDelete
  14. Not at all. I checked the Vanguard inflation protected securities fund I bought at the end of 2008 when I sold my bond funds in my Vanguard ROTH IRA and moved the proceeds to the TIPS fund. It was up 17.0%, beating total bond and GNMA by a wide margin since selling.

    In the core portfolio of my newsletter, I recommend a REIT fund (for income) that is up 15.88% YTD and CRUSHING GNMAs.

    2010 YTD through 7/31/10
    Vanguard S&P500 Index Fund - VFINX = -0.18%
    Vanguard Total Stock Market Index Fund - VTSMX = +0.57%
    anguard Total Bond Index Fund - VBMFX = +6.31%
    Vanguard Inflation Protected Securities Fund - VISPX = +4.20%
    Vanguard REIT Index Fund - VGSIX = +15.88%
    Vanguard GNMA Fund - VFIIX = 6.47%

    2009 Performance
    Vanguard S&P500 Index Fund - VFINX = +26.5%
    Vanguard Total Stock Market Index Fund - VTSMX = +31.9%
    Kirk's Explore Portfolio = +33.5%
    ===================================
    Vanguard Total Bond Index Fund - VBMFX = +5.93%
    Vanguard Inflation Protected Securities Fund - VISPX = +10.8%
    Vanguard REIT Index Fund - VGSIX = +29.58%
    Vanguard GNMA Fund - VFIIX = 5.29%

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  15. When researching bond funds, I appreciated the continuing exchange in the comments. All too often advisors make recommendations and you never see them re-visiting old decisions and analyzing what went right and what went wrong and what the alternatives have done.

    ReplyDelete

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