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The Increasingly Competitive Intermediate-Government Morningstar Category

Some things stay the same only by changing.

At the end of 2019, no funds in the intermediate-government Morningstar Category received a Morningstar Analyst Rating of Gold. By contrast, there were three Gold-rated funds five years ago: Fidelity Advisor Government Income FVIIX, Pimco GNMA and Government Securities PDMIX, and Vanguard GNMA VFIJX. Although the introduction of our new ratings methodology has something to do with that, it doesn't signal a deterioration in the resources of those top-shelf funds, as overall trends in the category have been evolving for several years. It does, however, reflect an increasingly competitive investment field, against the backdrop of a market with much less to offer than it used to.

Contexts Evolve For one thing, the universe of open-end intermediate-government fund options has shrunk. There were only 66 distinct open-end offerings at the end of 2019. That's a big change for a group that once dominated the bond-fund universe, and nearly that many were shuttered in just the past 10 years. By and large, the universe of survivors is a naturally more competitive group. At the same time, a number of exchange-traded fund options--such as iShares MBS ETF MBB, iShares GNMA Bond ETF GNMA, and Vanguard Mortgage-Backed Securities ETF VMBS--have come to market with lower pricing, further pressuring open-end rivals that have higher fee hurdles to clear.

The Federal Reserve's quantitative easing over the decade following the 2008 financial crisis changed precedent around how deeply the U.S. government would intervene to stabilize the economy, and the accompanying low-interest-rate regime that was once considered extraordinary has been somewhat normalized in its persistency. Couple this factor with the efficiency of the government-bond markets in general, and the historically narrow range of available excess returns in the intermediate-government category slimmed further over this period. Notably, this is reflected in our ratings 2.0 methodology, which demands that Morningstar Medalist funds exhibit an ability to outperform peers and their benchmarks after fees and adjusted for risk.

Meanwhile, admittance to any government-focused Morningstar Category requires that a strategy hold a minimum of 90% in U.S. government-backed securities; this parameter minimizes the credit risk of these portfolios, as the U.S. government is unlikely to default on its debt. It also keeps the category more homogeneous and straightforward than the intermediate core bond category, which is often where somewhat more adventurous strategies migrate after persistently outstepping this conservative constraint by pursuing plumper yields with allocations to nonagency holdings or asset-backed and commercial mortgage-backed securities. Instead, the teams behind intermediate-government strategies must industriously invest in a primarily agency-confined menu, seeking an edge by analyzing any number of nuances, such as the granular sliced-and-diced cash flows of collateralized mortgage obligations, and in some instances exploring newer or more esoteric structures, such as credit-risk transfer securities or even some mortgage derivatives. In challenging environments, the ability to ferret out a few basis points of return, often gleaned from deep research, separates the top or bottom performers in this increasingly data-driven category. It can also mean that there is significant effort expended for minimal reward when a strategy lacks a discernible and repeatable investment edge.

What Are the Implications for Our Recommendations? As the government-backed security landscape has evolved, so too have the exposure options for investors. A combination of a U.S. Treasury index and a mortgage-focused ETF can provide similar exposure at a much lower overall cost than some straightforward open-end intermediate-government strategies. But there are still those that have earned our confidence. These tend to have a compelling fee profile that provides a persistent advantage, given that there is a lower performance hurdle to clear in a category where returns are more concentrated and expected alpha ranges are narrow. A recommended strategy must also exhibit a clear and repeatable investment edge embedded in its process that increases the likelihood it will outperform its index and peers over time.

Ultimately, these investment edges are varied. For example, it may be access to relevant subsector specialists, such as those dedicated to mortgage derivatives, which can provide a boost along the portfolio's periphery when opportunities arise. Or it may be a demonstrated ability to select attractively priced cash flows consistently over a long period of time. Discussions with portfolio managers in the past few years have revealed the increasing importance of data in decision-making--both quality and quantity--coupled with tools to make better and better use of it. We seek evidence of this when recommending any actively managed government strategy.

A Few Intermediate-Government Recommendations While the intermediate-government category has evolved in a more competitive direction, a number of strategies continue to earn our confidence.

Fidelity Advisor Government Income benefits from a strong team and sensible approach that draws on the firm's deep mortgage analytics. It earns an Analyst Rating of Bronze across all share classes.

Vanguard GNMA will lose an experienced manager in mid-2020, 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 Silver rating, while its more expensive share class earns a Bronze.

BlackRock GNMA BGNIX accesses data, analytical tools, and a bevy of sector specialists when positioning this GNMA-focused portfolio. It earns a Bronze rating across all share classes.

JPMorgan Government Bond HLGAX applies the collaborative efforts of an experienced group of securitized specialists to this disciplined mortgage-centric offering. Those advantages are enough to award the strategy's cheapest share classes a Silver rating, while its more expensive share classes earn a Bronze or Neutral.

Pimco GNMA and Government Securities' Silver rating across its share classes reflects the advantage it gets from a well-equipped management team that has upheld a disciplined and differentiated approach to investing in Ginnie Mae mortgages.

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