Why Are GNMA Funds Dropping in Value?

Many investors are currently observing a decrease in the value of their Government National Mortgage Association (GNMA) funds. Understanding the factors influencing GNMA fund values, particularly interest rates and broader market dynamics, is important for investors. This article explores the primary reasons behind these value adjustments.

Understanding GNMA Funds and Their Interest Rate Link

GNMA funds primarily invest in mortgage-backed securities (MBS) issued by Ginnie Mae, the Government National Mortgage Association. These securities represent an interest in pools of mortgages, and Ginnie Mae guarantees the timely payment of principal and interest to investors, backed by the full faith and credit of the U.S. government. This government guarantee makes GNMA securities virtually free of credit risk. However, this guarantee does not protect investors from other market risks, such as interest rate fluctuations.

A fundamental principle in the fixed-income market is the inverse relationship between bond prices and interest rates. When interest rates rise, the market value of existing bonds, including those held by GNMA funds, typically falls. Conversely, when interest rates decline, existing bond prices tend to increase.

This occurs because the yield of a bond is calculated by dividing its fixed annual coupon payment by its price. If newly issued bonds offer higher interest rates, older bonds with lower rates become less attractive to investors, necessitating a price reduction to make their effective yield competitive.

How Rising Interest Rates Affect Values

A rising interest rate environment directly impacts the value of fixed-income investments like GNMA funds. When central banks, such as the Federal Reserve, increase benchmark interest rates to combat inflation or manage growth, it causes yields across the bond market to rise. This action makes newly issued bonds more appealing as they offer higher interest payments to investors. Consequently, existing bonds held within GNMA funds, which carry lower, fixed coupon rates, become less desirable.

To attract buyers in a higher-rate environment, the market price of these older, lower-yielding bonds must decline. This price reduction allows their effective yield to become competitive with newer, higher-yielding securities. The decline in market price directly translates to a decrease in the Net Asset Value (NAV) of bond funds. Even though the underlying Ginnie Mae securities are backed by the U.S. government, their market value can fall significantly when interest rates increase.

The Federal Reserve’s actions, particularly rate hikes implemented in response to surging inflation, have been a primary driver of this trend. For example, inflation surged to 6.6% in 2022, prompting the Fed to raise the federal funds rate by 5 percentage points over 2022-2023. This aggressive tightening cycle directly contributed to the decline in bond prices, as investors demanded higher returns. The impact of rising rates is typically greater for longer-term securities, making bonds with extended maturities more sensitive to these changes.

The Role of Prepayment Risk

Prepayment risk is a unique characteristic of mortgage-backed securities, including those in GNMA funds, that influences their behavior. This risk refers to the possibility that homeowners will pay off their mortgages earlier than anticipated, often due to refinancing or selling a home. For MBS investors, early prepayments mean receiving principal back sooner, which then needs to be reinvested, potentially at lower prevailing interest rates.

In a rising interest rate environment, prepayment speeds typically slow down. This happens because homeowners are less likely to refinance their existing mortgages if new mortgage rates are higher than their current ones. When prepayments slow, the average life of the mortgage-backed securities held within a GNMA fund extends.

This extension means the bonds behave as if they have a longer “effective duration,” which measures a bond’s sensitivity to interest rate changes. When effective duration increases, the securities become more sensitive to further interest rate increases, exacerbating the decline in value for GNMA funds during periods of rising rates. While the government guarantee ensures timely payments, the variability introduced by prepayment risk means the timing and amount of those payments can change, impacting the fund’s overall return and market value.

Wider Market Influences

Broader market influences also contribute to changes in GNMA fund values. Investor sentiment plays a role, with shifts in confidence leading to changes in asset allocation. When inflation is high or economic growth appears strong, investors may move away from fixed-income investments like GNMA funds, favoring equities offering higher growth potential.

This shift can lead to selling pressure on bond funds, contributing to price declines. General outflows from bond funds also put downward pressure on prices. If many investors redeem shares, fund managers may sell securities to meet redemptions, increasing the supply of bonds and pushing prices down. While fixed-income funds saw positive inflows in 2024, significant outflows occurred in 2022 and 2023, reflecting investor caution.

Market liquidity, or the ease of buying and selling securities without significantly impacting their price, also impacts fund values. In periods of market stress or uncertainty, liquidity in fixed-income markets can deteriorate, making it harder to trade securities at desired prices. Regulatory changes have also reduced the capacity of market-makers to hold large bond inventories, further impacting liquidity. These factors, combined with supply and demand, contribute to fluctuating GNMA fund values.