What is GNMA (Ginnie Mae)?

A is correct. GNMA certificates are backed by the full faith and credit of the U.S. government (same as Treasury bonds), making them extremely safe for conservative investors. They provide monthly cash flow from principal and interest pass-through, which suits Robert's need for regular income. However, unlike Treasury bonds with fixed maturity dates, GNMA certificates carry prepayment risk: when interest rates fall, homeowners refinance their mortgages, returning principal to investors earlier than expected, who must then reinvest at lower prevailing rates.

B is incorrect because GNMA certificates DO have full government backing, making credit risk minimal (equal to Treasuries). C is incorrect because GNMA certificates still have interest rate risk: if rates rise, the market value of existing certificates falls, and if rates fall, prepayments accelerate (reinvestment risk). D is incorrect on multiple counts: GNMA is a government-owned corporation (not private), and while GNMA yields are typically higher than Treasuries, this is due to prepayment risk and monthly payment structure, not credit quality differences.

B is correct. GNMA securities are backed by the full faith and credit of the U.S. government, making them the only mortgage-backed securities with direct government guarantee. This backing provides the highest credit quality, equivalent to Treasury securities.

A is incorrect because GNMA is a government-owned corporation within HUD, not a private entity. This distinguishes GNMA from Fannie Mae and Freddie Mac, which are private corporations with implicit (but not explicit) government support. C is incorrect because GNMA pass-through certificates make monthly payments of principal and interest, not semiannual payments like Treasury bonds. The monthly payment structure matches the underlying mortgage payments from homeowners. D is incorrect because GNMA interest is fully taxable at the federal, state, and local levels, unlike municipal bond interest which is federally tax-exempt.

B is correct. When interest rates fall significantly (from 5.5% to 3.5%), homeowners refinance their mortgages to capture lower rates. This triggers prepayment risk for GNMA investors: the underlying mortgages are paid off early, and the principal is returned to investors faster than originally scheduled. The investor must then reinvest this returned principal at the new, lower prevailing rates (around 3.5%), reducing future income. This is the primary risk of mortgage-backed securities during periods of declining interest rates.

A is incorrect because prepayments will reduce the outstanding principal balance, decreasing future interest payments below the original $5,500 annual amount as the principal base shrinks. C is incorrect because residential mortgages backing GNMA certificates typically do not have prepayment penalties, allowing homeowners to refinance freely. Even if penalties existed, they would go to the mortgage servicer, not the GNMA certificate holder. D is incorrect because prepayments return principal at par value (100 cents on the dollar), not below par. The investor receives full principal back but faces reinvestment risk, not principal loss.

C is correct (the EXCEPT answer). GNMA is NOT a private corporation. It is a government-owned corporation within the U.S. Department of Housing and Urban Development (HUD). This government ownership is what enables GNMA to provide the full faith and credit guarantee on its securities. This is a critical distinction from Fannie Mae (FNMA) and Freddie Mac (FHLMC), which are private, shareholder-owned corporations that were placed in government conservatorship during the 2008 financial crisis but are not government-owned entities.

A is accurate: GNMA securities carry the full faith and credit of the U.S. government, making them the only mortgage-backed securities with explicit government guarantee. B is accurate: GNMA pass-through certificates make monthly payments, reflecting the monthly mortgage payments from the underlying homeowners. This differs from Treasury bonds which pay semiannually. D is accurate: GNMA securities face prepayment risk because homeowners can refinance their mortgages when interest rates decline, returning principal to investors earlier than scheduled and creating reinvestment risk.

B is correct. Statements 1, 2, and 4 are accurate.

Statement 1 is TRUE: GNMA pass-through certificates make monthly payments of principal and interest (matching the underlying monthly mortgage payments), while Treasury notes pay interest semiannually. This monthly payment structure makes GNMA attractive for investors seeking regular cash flow.

Statement 2 is TRUE: GNMA certificates carry prepayment risk because homeowners can refinance their mortgages when interest rates fall, returning principal to investors early. Treasury notes have fixed maturity dates and do not face prepayment risk (though they can be sold before maturity at market prices).

Statement 3 is FALSE: GNMA certificates have the SAME credit quality as Treasury notes because both are backed by the full faith and credit of the U.S. government. GNMA is the only mortgage-backed security with this explicit government guarantee, giving it credit quality equal to Treasuries.

Statement 4 is TRUE: GNMA certificates typically yield more than comparable-maturity Treasury notes despite having equal credit quality. This yield premium compensates investors for prepayment risk, monthly payment structure (which complicates reinvestment), and slightly lower liquidity compared to the highly liquid Treasury market.