Killer Spreads

Marilyn Cohen, Forbes Magazine, 01.13.97

TWO CHEERS to the SEC for its efforts to cut the spreads on over-the-counter stocks. You would think that bond buyers had a protector in Washington.

Enormous spreads have been a way of life in bonds for as long as bonds have been around. A bond buyer's sole protection is a National Association of Securities Dealers guideline that suggests a 5% maximum markup or markdown. Some protection. It means you can be clipped "only" 10% of your capital if you sell one bond and buy another. And even that guideline is just that higher charges are not necessarily deemed excessive.

Don't take this as advice that you should never buy bonds, but take it as warning to shop around when you trade.

Let's focus on one important bond category, the mortgage passthroughs issued by the Government National Mortgage Association.

Ginnie Maes are guaranteed against default by the federal government and can yield about a percentage point more than comparable Treasury bonds. Ginnie Maes, however, have two disadvantages: Their interest is subject to state income tax, and their maturity is unpredictable (because homeowners refinance their mortgages if interest rates go down).

For people who must pay state income taxes, the advantage of a Ginnie Mae over a Treasury is just about wiped out by these two disadvantages. But if you don't pay state income taxes (Texas, Washington, etc.) or you invest through a tax-deferred IRA or 401(k), Ginnie Maes probably out yield Treasurys. ;

But beware of those spreads. Here are four rules to follow:

Don't trade. Buy a Ginnie Mae only if you can be reasonably sure that you (or your heirs) will hold it until the last principal payment comes in, either 15 or 30 years after issuance.

Use more than one broker. Get two quots before placing an order. This is especially important if, against your expectations, you have to sell. I once sold for a client $296,000 (principal balance) of the Ginnie Mae 8s due May 15, 2002, issued in 1987. I called two wirehouses for bids, one bond broker and one large bank. The bids ran from 100 1/2 to 102 3/4, a $6,600 difference!

I recently shopped around for $500,000 of Ginnie Mae 8 1/2s with a seasoned payment history and an expected average maturity of ten years. The offering prices were 2 1/2 points, or $12,500, apart.

If you don't have two brokerage accounts, you can always try haggling. Say the broker wants 103 1/2 for a Ginnie Mae 8 1/2 with an average life of ten years. Offer 103.
Don't be a piker. When issued, Ginnie Maes come in lots as small as $25,000, but it does not make sense to buy less than $100,000.

Remember, those principal amounts shrivel after a period of falling rates, which causes homeowners to either move or refinance. One client owned what was originally a $75,000 piece of a Ginnie Mae 10% issued in 1980. When it came time to sell, the entire $4 million pool had dwindled to $756,000, and my client's piece to $14,500. One broker refused to bid. The bids that came in were all over the map, 102 1/2 to 107 1/2. ;

I recently shopped around for $500,000 of Ginnie Mae 8 1/2s. The offering prices were $12,500 apart.;

Know your bonds. You should know the original face amount of the pool you are taking a piece of, what part of the country the mortgages are located in and, if the pool has been around for a while, what its history of prepayments has been. Location matters a great deal because people with mortgagesin Florida move less frequently and prepay more slowly than people who have mortgages in California.

Before placing an order to buy or to sell, get an idea of the prices quotd to institutional buyers by looking at listings in the Wall Street Journal or a quot service like Bloomberg. But note that these prices are estimates or synthetic prices constructed from composites of real trades. There is no one exact price for any given maturity date and coupon. Every pool is slightly different because of prepayment history, geography and coupon interest.

After reading all this, you may decide the game isn't worth the effort. Before you walk away, consider Ginnie Mae mutual funds. A no-load fund can handle all the trading headaches at a cost of as little as 0.3% a year, with no bid/ask spread. If you need liquidity, the fund provides it.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed income money manager. Visit her home page at www.forbes.com/cohen.

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