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Fund Spy

Government Bonds and Risk Aren't Mutually Exclusive

There is no such thing as a free lunch when it comes to government bond funds that consistently out-yield their peers.

In the early 1990s when investors were migrating out of CDs in search of bigger yields but still looking for safety, government bond offerings--usually heavy with mortgage securities--were very popular. At the beginning of 1993, intermediate-term government funds comprised more than a third the assets of all taxable-bond offerings. Today, this Morningstar Category accounts for only 3% of the money in taxable-bond funds.

Diminished interest from investors has arguably translated to fewer firms chasing market share with tricks of the trade to jack up their yields, something that was more rampant and destructive back when the group was much larger. There are still funds willing to take on extra risk to separate themselves from the pack, though.

To qualify as a government offering by SEC naming rules, funds needn't hold more than 80% in bonds with U.S. government-related debt. Morningstar's guidelines require funds to keep at least 90% in government exposure to stay in that class, though, and there are a handful of offerings that land in the intermediate-term bond category, for example, because of this. A couple are run by well-known firms, including the $2.1 billion  Columbia U.S. Government Mortgage (CUGYX) and Hartford U.S. Government Securities (HAUSX), each of which usually hold more than 10% in some mix of non-government-agency securities supported by residential, commercial, or asset-backed debt.

Government and Risk Aren't Mutually Exclusive
Even keeping 90% in government exposure still leaves room for funds to try to get ahead of the competition by taking on risks outside of their normal territory. Sometimes that involves pushing against that limit, but some funds use holdings technically backed by government debt but whose complex structures can help enhance returns.

Principal Government and High Quality Bond (PMRIX) is among the intermediate-government category's most prolific income producers, for example, and the fund does hold some nongovernment items that have helped push up its payouts. As of its April 2017 semiannual report, it held nearly 10% in a similar mix of non-government securitized assets, as well as nearly 11% in interest-only government-agency backed mortgage tranches that typically offer generous payouts in exchange for magnified prepayment risks. In addition to using mortgage forward contracts to help it gain more market exposure, Putnam U.S. Government Income (PUSYX) gets a yield advantage over plain-vanilla offerings with the same kind of more-complex government-backed interest-only, principal-only, and inverse-floater mortgage tranches.  Eaton Vance Short Duration Government Income (EILDX), meanwhile, has a history of holding a mix of both nongovernment exposures--including low-quality bank loans--and risky government mortgage tranches. Neither are particularly suited to categories popular as destinations for safety.

Know From Whence Thy Yield Comes
Taking risks on the margins isn't necessarily a red flag, but a fund that is consistently able to out-yield its peers is always worth a careful look given that fat income payouts can be a telltale sign that significant extra risk is being taken. It's axiomatic, especially among more-efficient markets such as those for government securities, that while one can pick up incremental gains in less popular corners, it's nearly impossible to generate significant extra return without commensurate risk. In the yield-chasing days of the late 1980s and early 1990s, a handful of funds billed as "safe" thanks to their government focus badly burned some of their most vulnerable investors when their yield-pumping risks were borne out by market volatility that otherwise left more modest scratches on their peers. Fortunately, there are well-run, fairly priced funds with excellent records that tend to keep their risks well in line with government markets, including  Fidelity GNMA (FGMNX),  Fidelity Government Income (FGOVX), and  Vanguard GNMA (VFIIX), each of which carries a Morningstar Analyst Rating of Gold.  

Eric Jacobson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.