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A Downgrade for This Vanguard Bond Fund

Among the largest in the intermediate government category, Vanguard GNMA will soon lose its longtime manager.

The following is our latest Fund Analyst Report for Vanguard GNMA VFIJX. Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

A large asset-allocation team, solid underlying managers, and low fees solidify T. Rowe Price Retirement Balanced's Morningstar Analyst Rating of Silver.

This fund served as the landing point in the firm's Retirement target-date series from 2002 until 2004, when the glide path stopped derisking at 40% in equities 10 years past retirement. In 2004, the firm revisited the glide path and decided to continue trimming equities until 30 years past retirement; at that point, the stock weighting levels off at 20%. As a result, this fund was eventually decoupled from the series.

Vanguard GNMA is losing an experienced contributor, but its thoughtful and risk-aware approach to the agency mortgage markets remains compelling. This is enough to award the strategy’s cheapest share class a Morningstar Analyst Rating of Silver, while its more expensive share class earns a Bronze rating. After two decades contributing to this Wellington-subadvised strategy, long-tenured lead manager Michael Garrett will retire in June 2020. In 2012, Garrett selected Brian Conroy, a former bond trader, as an agency mortgage analyst here; in mid-2019, Conroy was formally appointed to the portfolio management roster along with Joe Marvan, a senior fixed-income markets generalist at the firm. Though a structured finance analyst, two traders, and two quants are identified as further contributors here, relative to peers, this team is both thinly staffed and, without Garrett, a rather fresh configuration. The team employs a value-leaning approach and selects bonds that look cheap relative to their likely cash flows, primarily focusing on GNMA mortgage pass-throughs. Fannie Mae- and Freddie Mac-backed fare (around 16% of assets as of September 2019) function as modest out-of-benchmark allocations along the portfolio’s periphery. As of September 2019, roughly 75% of holdings were GNMA securities--around 10 percentage points lower than the year prior--as the team found more-attractive valuations in Fannie Mae- and Freddie Mac-backed fare. The strategy’s steadfastness has paid off over time. For instance, it performed comparatively well in 2008's risky credit markets, when some of its more adventurous peers fell behind. Over the 15-year period ended October 2019, the strategy’s investor share class delivered an annualized 4.0% and topped 85% of a subgroup of distinct mortgage-focused peers in its intermediate government Morningstar Category; it also kept pace with its Bloomberg Barclays U.S. GNMA Bond Index. Of note here, rock-bottom fees translate to a persistent edge relative to peers that must clear a higher performance hurdle.

Process|Above Average|by Emory Zink Nov 26, 2019

A disciplined and risk-conscious approach to this agency mortgage-centric mandate justifies an Above Average Process rating. Comanagers Michael Garrett and Brian Conroy primarily stick to buying GNMA mortgage pass-throughs, which come with an explicit U.S. government guarantee. The strategy will also hold small allocations to mortgages backed by Fannie Mae and Freddie Mac or U.S. Treasuries when GNMA pass-throughs start to look relatively expensive. Such exposures usually make up 10%-15% of assets combined. The team avoids more-esoteric fare, such as interest-only mortgage derivatives, which are more sensitive to prepayment risk. The strategy’s duration is kept within a half year of the Bloomberg Barclays U.S. GNMA Bond Index, but on occasion the team has shortened or lengthened it by more than a year than that benchmark when it believes the environment merits the positioning. The team also actively calibrates the portfolio’s prepayment risk profile, which is where its careful evaluation of macroeconomic factors and government policies and bottom-up assessment of underlying loan characteristics come into play. At times, Treasury futures or mortgage TBAs (a type of forward agreement used to gain generic exposure to various coupons and collateral) are employed when the team thinks these are priced attractively relative to cash bonds.

The comanagers stick to the strategy's mandate, resulting in a portfolio overwhelmingly dedicated to GNMA mortgage pass-throughs with modest allocations to Fannie Mae- or Freddie Mac-backed mortgage bonds when they present a good value. As of September 2019, roughly 75% of holdings were GNMA securities--10 percentage points lower than the year prior--as the team found more-attractive valuations in Fannie Mae- and Freddie Mac-backed fare. Though the team reduced its exposure to Fannie Mae delegated underwriting and servicing bonds to 3% from 6% over that period, as spreads tightened on those holdings, Michael Garrett and Brian Conroy took the opportunity to rotate into agency collateralized mortgage obligations that it viewed as having a better convexity profile. Around a percentage point of Freddie Mac seasoned credit-risk transfer securities also debuted in the portfolio. The team extensively models prepayment risk and selects securities that are priced attractively relative to their projected cash flows. Over time, the strategy has used a mix of TBAs and mortgage pass-through securities, adjusting allocations depending on relative valuations. The portfolio's average duration of 2.6 years in late 2019 ran modestly longer than the bogy's 2.5 years.

People|Average|by Emory Zink Nov 26, 2019

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