An article in Sunday's Business section incorrectly stated that dividends on Ginnie Maes are exempt from District of Columbia taxes. The law was changed in 1984, making such income taxable.
"Triple your money in just 12 years with U.S. Government Backed Ginnie Maes" promises an advertisement placed by a New Jersey securities broker. A Florida firm claims its "14 percent coupon Ginnie Mae combines growth and safety."
"There can be a big difference in the interest your IRA earns. Compare our rates on Ginnie Maes to the banks." says another. "Don't roll over your CD's until you look into Ginnie Maes," advises a fourth.
With less than a month to go to the April 15 tax-filing deadline, it is the height of the season for individual retirement account investments. Few are being pitched harder right now than securities of the Government National Mortgage Association.
These Ginnie Maes, as they are known, allow investors to buy into pools of home mortgages underwritten by the Federal Housing Administration or the Veterans Administration. These two government agencies stand ready to make good on any homeowner defaults, and the Government National Mortgage Association, part of the Department of Housing and Urban Development, guarantees that borrowers' payments reach the owners of the securities.
Those two often-advertised "government guarantees" do not protect Ginnie Mae investors if the mutual fund manager goes broke or steals customers' money, nor do they guarantee that interest rates won't soar or stumble, dramatically changing the yield on the investment.
Ginnie Maes do, in fact, provide exactly what the Government National Mortgage Association promises they will. But whether that adds up to safety and high yield depends on how an investor buys them and what his or her goals are.
A Ginnie Mae investment starts when a buyer of a single family house gets a mortgage insured by the FHA or VA from a lender. The lender combines this new mortgage with other similar loans into a pool totaling $1 million or more. Certificates are then sold to investors, entitling their owners to a share of the payments of principal and interest as the borrowers make payments on their loans.
The investors' cash flows back through to the lenders, providing them with money to make more loans. This is the underlying purpose of the system.
Since the GNMA certificates represent shares in the mortgage pool, they have the same maturity as the mortgages, and carry an interest rate slightly below the rate paid by the homeowners on their loans. This rate is called the "coupon" -- currently 9 percent -- and is the rate an investor will get if he buys a new Ginnie Mae at par.
Since tens of millions of dollars in FHA and VA loans are written each month, and since interest rates fluctuate, there are large numbers of Ginnie Maes outstanding at any given time carrying different coupons and maturities. These are bought and sold on the open market. Like bonds, their prices fluctuate to bring their yields into line with current market conditions.
The government does not protect Ginnie Mae owners against market risks. When interest rates change in the market, the prices of Ginnie Maes tend to move in the opposite direction. Thus, when interest rates rise, the prices of Ginnie Maes move down. This can be no more than a paper loss for the investor who continues to hold his Ginnie Mae, but anyone who has to sell can face some real red ink.
The government also does not protect Ginnie Mae investors against premature payoff. Since people sell their houses, a certain number of loans in a given pool will pay off each year. But if interest rates plunge, the payoff rate accelerates, and if an investor has bought his Ginnie Mae at a premium, he will suffer a loss. It also means that although the securities may have nominal maturity 30 years, an investor can, and usually will, get his money back long before that.
Some ads invite investors to "lock in high interest rates" while rates are falling. Yet Lawrence A. Friend, an accountant with the Securities and Exchange Commission, notes that while it may be possible to lock in for a year, it is impossible to do so over the long term.
Finally, the government does not protect investors who are not actually the owners of Ginnie Maes. Since the securities are sold in minimums of $25,000, few individuals are willing or able to buy one themselves. Most people who invest in Ginnie Maes do so through mutual funds or so-called unit trusts.
In these, it is the fund or the trust that actually owns the Ginnie Maes, and the government guarantee means only that the fund or trust can be sure of receiving the payments it is due.
If the fund or trust collapses, or its operator skips the country, the investor is left to his own devices in recovering his money.
In addition, uninsured brokers may sell whole Ginnie Maes to customers, but retain title to them in what is called "street name." If such a broker goes under, the investor can lose his money.
Yields on Ginnie Maes are commonly calculated on a 12-year maturity without prepayment. But if there is a substantial decline in interest rates, there will be more prepayments and the average life of the pool will be shorter. For example, last September, Salomon Brothers Bond Market Research estimated the average remaining life of a 13 percent coupon Ginnie Mae issued in 1983 at 7.2 years; for a 15 percent Ginnie Mae, it was 2.7 years.
If an investor buys a discounted Ginnie Mae and it pays off sooner than expected, the return will increase, since payoffs are always at par. Conversely, if an investor pays a premium and the Ginnie Mae pays off sooner than expected, the investor will get a lower return. For example, if one buys an 8 percent coupon at 85 percent of par and expects to get 100 in three years, but does not get it for six, then the anticipated return is reduced. If, on the contrary, the $100 comes back in one year, the return is increased.
One analyst calculated that prepayment rate on a 12 percent coupon Ginnie Mae could be as high as 30 percent annually under current conditions, which would reduce the yield to 8.7 percent, little better than comparable Treasury issues.
Robert T. Reeves, senior vice president of Ferris & Co., advises an investor expecting a decline in interest rates to buy Ginnie Maes selling at a discount because they appreciate more than those with high coupons sold at a premium. However, since rates have come down so much recently, most outstanding Ginnies are selling at a premium.
Capital Expansion Group of McLean sells Ginnie Maes issued several years ago. A customer would pay in the $5,000 to $12,000 range for a $25,000 face certificate. President Bill Ciosek says he sells only lower discounted Ginnie Maes bearing when-issued interest rates in the 7 percent to 10 percent range. The actual yield will be over 12 percent if the Ginnie Mae pays back quicker than expected. On the other hand, if rates rise, the yield will be lower than anticipated.
The effect of interest rate changes can be dramatic on the actual yield. Reeves points out that what he calls the "honest-to-goodness" yield on a 14 percent coupon Ginnie Mae bought at a premium, with a current yield of 12.75 percent, is 11.50 percent because the average life span of the investment is just 6.17 years. If interest rates drop 2.5 percentage points, that 11.5 percent yield will drop to 6.28 percent as prepayments increase. If rates move up by that amount, the final yield will be 13.09 percent because the investment will last over 11 years.
Investors should also note that many advertised yields assume that principal is reinvested as it is returned. If it isn't, the advertised yield will not be achieved.
The investor who finds these calculations too esoteric can invest in Ginnie Maes by buying shares in a unit investment trust or a mutual fund where they are professionally managed by people who understand the vagaries of the market. The securities in mutual funds are continuously traded, whereas those of a unit trust are usually set until maturity.
Sales of Ginnie Mae mutual funds last year totaled $12.7 billion, up from $2.9 billion the year before. Sales of government income funds, which often include Ginnie Maes, zoomed to $34.3 billion from $5.8 billion. Sales of Ginnie Mae unit investment trusts totaled $851.3 million, versus $586.2 million a year earlier.
The value of unit investment trusts tends to drop sharply when interest rates rise and recover at a slower pace when rates decline. Mutual funds, on the other hand, reinvest the repaid principal in other Ginnie Maes, preventing sharp reductions in the account's value.
When an investor buys into a mutual fund, there is virtually no way of knowing the maturities of the wide variety of mortgages behind it; moreover, they are constantly changing. The actual return depends on interest rates, how well the portfolio is managed and whether the principal and interest are reinvested at the same rate, factors beyond the investors' control.
Yield calculations and advertising of Ginnie Maes, both whole and as shares of mutual funds, promote confusion.
Performance can be stated as both yield and total return. For example, assume that $1,000 is invested in a 10 percent Ginnie Mae on Jan. 1, 1986. One year later, the account has earned $100 interest. In addition, $150 of the $1,000 principal has been repaid, so the remaining principal amounts to $850. Total return for 1986 is thus 10 percent and yield is also 10 percent. If, however, market interest rates have dropped during the year, the value of the $850 principal has increased to $950. When added to the $100 interest and $150 repayment, the account totals $1,200. The total return for 1986 becomes 20 percent; the yield is 10 percent.
Aside from knowing the difference between yield and return, the investor should know there are various ways of computing and advertising yields. According to Michael Lipper, president of Lipper analytical Services Corp., which tracks mutuals funds, the data supplied to his company by the funds often do not support the claims made in the ads.
Since there are no required standards for computing yields, sellers often choose the method that makes them look best. One may use the average total return, the average 12-month yield including capital gains, or the average annualized yield, calculated on the monthly dividend without capital gains distribution, or even anticipated dividends. Computations are further complicated by unresolved disputes within the industry over the accounting treatment of options written on the portfolio, and whether the discount, or premium, should be amortized against current yields.
This year, yields computed on longer than 30-day periods tend to be higher than those on periods of fewer than 30 days because of the steady decline in interest rates.
The yield calculated on the basis of the latest short-term performance may provide the best basis of comparison with other fixed-income investments, according to the Investment Company Institute, the trade group for mutual funds.
Dividends on Ginnie Maes are subject to federal taxes, but not to state and local taxes in Virginia and the District. They are taxable in Maryland.