Long-term interest rates continue to tumble as investors are scurrying about trying to "lock in" high interest rates. In an effort to maintain as much income as possible, buyers have extended maturities, going after the higher returns available in 10-, 20- and 30-year terms.
Government National Mortgage Association securities, known better as Ginnie Mae's, are being eagerly sought because of their high returns and their U.S.-government backing. GNMA's are created when mortgages are pooled together and a GNMA certificate is issued evidencing partial ownership of the mortgages in that pool. The pool receives monthly payments of principal and interest from the mortgages, which in turn are passed on to the owners of the GNMA certificates. The government guarantees the timely payment of this principal and interest to investors. Buyers of GNMA's should be aware that since the payments are both principal and interest, when a pool expires, there will be no principal left. You receive nothing, unlike other bonds which at maturity return to the owner the amount lent to the borrower. There are other factors that buyers should understand.
The yield on a GNMA is determined by the coupon rate, the price and a prepayment assumption. Put simply, a prepayment assumption is the length of time or the "speed" that it takes for a pool of mortgages to pay down to zero. A prepayment risk occurs when a number of mortgages in a pool prepays at par ($1,000) either through default or refinancing, even though the GNMA security may be owned at a premium (price above par). As interest rates decline, the probability of refinancing mortgages increases dramatically. This is why high-coupon GNMA's are risky, because prepayments in mortgage pools are passed on at par ($1,000). As a result, the owner of the GNMA purchased at par plus a premium (i.e., $1,085) will lose the premium ($85) as the issue is prepaid at par.
Another point, if the pool is made up of mortgages with high interest rates on them, they will be prepaid at a faster pace. So, instead of owning a GNMA for 12 years or so, if there is a fast prepayment, an investor might end up owning it for 6 years or more.