Thousands of investors were shocked this spring to see their "government guaranteed" mutual funds go down in value. And another shock is on its way. Many of you will find that you are not getting the sky-high yields that were promoted in the advertisements.
I'm speaking principally to those who bought into Ginnie Mae funds -- portfolios of mortgages backed by the Government National Mortgage Association. (Many other "high-yield" government-securities funds are committing crimes against common sense, but that's another story.)
Industry professionals are speaking out against the questionable sales techniques that have attracted more than $41 billion from investors. Many investors mistakenly thought that Ginnie Maes were as safe as certificates of deposit, while paying higher interest rates.
"Ginnie Mae funds grew quickly because they were advertising yields so much greater than the market offered," Gary Peters, senior vice president of The Exchange National Bank of Chicago, told my associate, Virginia Wilson. At a time when long-term Treasuries are paying 7.1 percent, Franklin's U.S. Government Securities Fund (mostly Ginnie Maes) is promoting itself at 11 percent.
The trouble is that 11 percent, and similar yields from many other Ginnie Mae funds, present only part of the story.
If a mutual fund buys high-interest mortgages (in order to show eye-catching yields), it usually pays more than the face value shown on the loan. When interest rates drop, homeowners rush to refinance those expensive mortgages -- but, of course, they repay only the face value. When that happens, the Ginnie Mae fund sustains a loss.
Unfortunately, many funds, when advertising yields, don't subtract the built-in loss that inevitably occurs whenever the mortgage is repaid. If they did so, Peters charges, they would have to admit that their true yield is closer to 8 or 8.5 percent, after prepayments and sales commissions.
I can't tell you exactly how this works out for the Franklin fund. Chuck Johnson, the fund's marketing director, refuses to comment on Peters' view of his arithmetic. "When I have, I've been hatcheted," he complains. But whenever you cash in your mutual-fund shares, your return will reflect the realities of the market rather than the illusions of mutual-fund accounting. You should be suspicious of any fund advertising more than about 9.5 percent.
Let me hasten to add that there is nothing wrong with investing in Ginnie Mae mutual funds. They're paying acceptable long-term yields, even though you may not be getting as much as you thought.
But Peters believes that you could be earning 0.5 to 1 percentage point more by buying single Ginnie Mae securities instead of joining a mutual fund. A newly issued security costs a minimum of $25,000, but older ones can be had for much less -- say, in the $10,000 to $15,000 range.
You'd buy individual Ginnie Maes through a brokerage house. But a mutual fund is your only choice if you have only $1,000 or $2,000 to invest, or if you want your dividends automatically reinvested.
A final point about Ginnie Mae funds, one that inexperienced investors didn't learn until recently: You run the risk of losing money. The funds' widely touted "guarantee" means only that no defaults will be allowed on the underlying mortgages. Uncle Sam does not guarantee the market value of your fund shares, does not promise that you won't lose money and does not underwrite the advertised yields.
At the end of May, investors in Ginnie Mae funds had lost an annualized 1.5 percent of their principal since January. Fund dividends also were cut. Counting reinvestment of dividends, the funds as a whole have gained only 2.7 percent this year.
Over the past 12 months, the funds are up a total of 12.7 percent (counting dividends and capital appreciation), according to Lipper -- which is an entirely respectable return. But this compares with a much higher 19 percent for funds invested principally in Treasury securities. Why the big difference? Ginnie Mae funds are being devastated by prepayments while Treasury mutual funds are not.
A Ginnie Mae "Plus" fund, incidentally, tries to squeeze an even higher yield for investors by selling options on its securities. That can work when interest rates are steady. But when interest rates fall, that Plus turns into a minus, leaving investors even further behind.
At some points last year, Ginnie Mae funds were outperforming Treasuries -- and in theory, they should again. And even if their share values are not doing as well, they are paying higher current interest. But these are complicated investments, not the sure things that some of you may have thought.