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Which Vanguard Bond Fund Is Right for You?

In Vanguard’s large stable of bond funds, not all make the cut

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VFIIXchartExpenses: 0.21%

Despite lackluster performance in the Vanguard GNMA Fund (VFIIX) this year, I continue to have confidence in this fund.

GNMAs (often referred to as Ginnie Maes) are bonds backed by mortgages. The Government National Mortgage Association buys home mortgages from banks, combines them into large packages of loans with roughly the same maturities and interest rates, then resells them to institutional investors. The result is a bond with a government guarantee but a relatively higher yield because it isn’t as straightforward as a Treasury bond.

GNMAs have a unique risk, called “prepayment risk,” in that the underlying mortgages can be repaid early. If interest rates fall, homeowners might refinance, and if a mortgage with a higher rate of interest is paid off and replaced by one with a lower rate, the GNMA bond holding that original mortgage returns the principle to the bond owner — it no longer holds that higher-yielding mortgage. So when interest rates (and particularly mortgage rates) are falling, investors tend to shun GNMAs. But in rising-rate environments, those mortgages stay put, and the fund’s extra yield helps to carry the day in the total return race.

In any case, there’s less prepayment risk in this fund than in most GNMA funds, as manager Mike Garrett of Wellington focuses on bonds whose underlying mortgages are “seasoned,” or less likely to be repaid early.

Because GNMAs are less-understood, many investors don’t know how to use them in a portfolio. Vanguard’s online “planning” tool recommends other intermediate-term bond funds in place of GNMAs. And Vanguard’s personal financial planning team rarely, if ever, recommends the fund because their computers just don’t get it. This creates opportunity.

By spending a little extra time to understand GNMAs, you can pick up yield compared to Total Bond Market — 2% vs. 1.51% — while also reducing interest-rate risk.

Editor Dan Wiener and Research Director Jeffrey DeMaso publish The Independent Adviser for Vanguard Investors, a monthly newsletter that keeps abreast of recent developments at Vanguard, and the annual FFSA Independent Guide to the Vanguard Funds.

Article printed from InvestorPlace Media,

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