T. Rowe Price GNMA Fund - November 30, 2005

N-CSRS 1 srgma.htm T. ROWE PRICE GNMA FUND T. Rowe Price GNMA Fund - November 30, 2005

Item 1: Report to Shareholders

GNMA Fund

November 30, 2005

The views and opinions in this report were current as of November 30, 2005. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the fund’s future investment intent. The report is certified under the Sarbanes-Oxley Act of 2002, which requires mutual funds and other public companies to affirm that, to the best of their knowledge, the information in their financial reports is fairly and accurately stated in all material respects.

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Fellow Shareholders

Mortgage-backed securities experienced a difficult environment over the past six months. While the Fed continued to raise official short-term interest rates at a “measured” pace, rates on longer-term securities fluctuated significantly as investors weighed monetary policy against other factors, including strong economic growth and the inflationary impact of record oil prices. Mortgages typically struggle in the face of such volatility, and the sector offered flat returns during our reporting period.

MARKET ENVIRONMENT

The economy continued to expand throughout the past six months, apparently slowing only slightly in the aftermath of the widespread destruction wrought by Hurricane Katrina in late August. According to the latest estimates, gross domestic product grew at a 3.3% annualized rate in the second quarter and a 4.3% rate in the third. While the headline data on inflation were less welcome—consumer prices rose substantially in July and August, and then spiked 1.2% in September—this was mostly due to record-high oil prices; in fact, inflation then fell back to a modest 0.2% rate in October. The core rate of inflation, which excludes food and energy, rose at a steady and modest 0.1% monthly rate through September before ticking upward to 0.2% in October. Although the hurricane took a large toll on Gulf Coast employment, the national labor market remained healthy, and the unemployment rate stood at only 5.0% in November.

Even as the economy grew steadily, the past six months were extremely volatile for fixed-income securities. Yields climbed roughly 100 basis points (one percentage point) at the short end of the Treasury yield curve, while the 10-year rate rose only 50 basis points and the 30-year rate increased 37 basis points. Although this dramatic yield curve flattening was anticipated as the Federal Reserve took care to telegraph its tightening policy, a pattern of substantial volatility underlay these moves. The yield on the 10-year Treasury note began the period at 3.98%, rose as high as 4.43%, fell back to 4.00%, and ended at 4.48%. The fluctuations were driven by various factors, such as Fed policy, soaring oil prices, fears of an economic slowdown due to the hurricanes, and the downgrade of Ford and GM debt to high-yield status.

THE FED’S ROLE AND WHAT IT MEANS TO YOU

After the January 31, 2006, Federal Open Market Committee (FOMC) meeting, Chairman Alan Greenspan will retire. His successor will be Ben S. Bernanke, currently the chairman of President Bush’s Council of Economic Advisers, and former Fed governor and Princeton professor. Mary Miller, director of T. Rowe Price’s Fixed Income Division, says, “For 18 years Alan Greenspan has been a steady hand at the Fed’s helm, guiding us through volatile financial markets and geopolitical events with sound reasoning and long-term perspective. His inflation-fighting resolve has structurally lowered inflation expectations, leading to milder business cycles and greater prosperity.”

Why should you care about the Fed’s moves or Greenspan’s successor? The short answer is the central bank’s actions—including setting monetary policy and overseeing the integrity of the banking system—impact mortgage rates, credit card costs, and fixed-income yields. At the most visible level, the Fed raises short-term interest rates to curb inflation when the economy is growing quickly and lowers them when it wants to stimulate economic growth. The chart below shows the FOMC systematically lowering rates in 2001 as the economy slipped into recession following the implosion of the dot-com bubble. Once the economy gained traction, the Fed started raising the fed funds rate. The stairstep increases from mid-2004 to date have had the desired effect of slowing GDP growth while keeping inflation from accelerating. Most credit-market experts correctly anticipated the December 13 rate increase and expect another quarter-point rate hike at the January 31 FOMC meeting.

Miller thinks that Bernanke’s monetary policy should dovetail seamlessly with Greenspan’s. In his statement to the Senate Banking Committee, Bernanke affirmed, “under Greenspan, monetary policy has become increasingly transparent to the public and financial markets, a trend I strongly support.” This focus, in Miller’s view, is a positive for credit-market stability. She added, “The incoming chairman’s pledge to target the inflation level he considers consistent with long-term price stability is not a departure from present practices and should continue to benefit fixed-income investors.”

PERFORMANCE AND STRATEGY REVIEW

The GNMA Fund returned 0.03% and 2.16% for the 6- and 12-month periods ended November 30, 2005, respectively. As shown in the table, the portfolio outperformed the Lipper GNMA Funds Average but lagged the Citigroup GNMA Index in both periods. The fund’s net asset value declined by $0.22 over the past six months, which was offset by the same amount in dividends paid out over the period.

The volatile interest rate environment since May was very tough on mortgages, which perform best when rates remain tame and securities trade in a fairly tight range. Over the last six months, as measured by Lehman indexes, mortgages returned -0.16%, while GNMAs performed somewhat better, returning 0.11% over the same period. Most of that outperformance occurred in the last four months as foreign investors showed a preference for GNMAs. Another factor supporting prices was shrinking supply. At the end of November GNMAs represented 11.0% of the overall Lehman mortgage index, compared with 12.4% only 13 months ago. Investors such as ourselves are reluctant sellers into a market that is becoming smaller, as we risk not being able to buy back bonds at a later date. Excess returns on mortgages (returns compared to equal-duration Treasuries) over the last six months were a negative 39 basis points; most of the under-performance occurred over the past three months. The negative performance was attributable to spread widening and the volatile interest rate environment.

Given the expectation of rising interest rates, our posture during the year was defensive. We maintained a shorter duration compared with the Citigroup GNMA Index, and we chose securities that were less susceptible to volatility in interest rates. In particular, we overweighted 15-year mortgages, which have much less extension risk, or the potential to lock us in to lower yields in a rising rate environment. We also owned collateralized mortgage obligations and project loans sponsored by the Government National Mortgage Association. Project loan deals are backed by a group of commercial real estate loans, primarily to nursing homes, assisted living facilities, and multifamily housing for low- and moderate-income families. They are diversified by geography and structured with strong call protection. These types of securities benefit a portfolio by adding stability to the average life of the portfolio compared with an all-mortgage fund. We also carefully select the pass-throughs that we own—looking for better protection against volatility and superior return potential than what is available in the “to-be-announced” (TBA) market.

The mortgage sector is at an interesting point. Yield spreads have widened, offering more yield advantage relative to Treasuries than we have seen in over a year; however, when compared with spreads of many years ago, they still appear somewhat narrow. Likewise, implied volatility, which is a negative factor for mortgages (please see glossary), has come off its recent lows but remains fairly low compared with previous years. While low or even negative supply has supported mortgage prices over the last several months, the supply of conventional mortgages has been ticking up recently and should continue to be positive for the next several months. GNMA supply will continue to be flat to negative as long as the subprime mortgage market continues to flourish, offering homeowners an alternative to GNMAs. On the other hand, higher short-term rates have reduced the benefit to homeowners of moving into hybrid adjustable-rate mortgages instead of 30-year fixed mortgages and, in fact, may cause some hybrid borrowers to refinance back into 30-year loans. This would only increase supply in our sector.

Finally, demand continues to be the wild card. The government-sponsored entities, FNMA (Fannie Mae) and FHLMC (Freddie Mac), have been sidelined from investing in the mortgage market because of their accounting problems and the political environment. The Office of Federal Housing Enterprise Oversight just announced that Fannie Mae has met its capital requirements, however, and Freddie Mac has been in a positive cash position for several months. While we do not anticipate Fannie Mae becoming a major buyer of mortgages given recent problems, we may see Freddie Mac become a larger buyer given that the spread between mortgages and agency debt has widened to attractive levels. Foreign buyers have been very quiet over the last few months as well, despite widespread anticipation that they would become active investors after rates rose. Banks are another potential source of demand, but they are generally not interested in mortgages when the yield curve is flat because they are unable to buy mortgages with money borrowed at cheaper short-term rates.

OUTLOOK

Recently, mortgages have tended to underperform Treasuries and swaps when interest rates have risen, while doing much better when rates are falling. On balance, this bodes well for the coming months. The Fed appears to be nearing the end of its tightening cycle, which promises to allow interest rates to find a comfortable trading range. However, we may see more volatility as we go through the next few rate hikes, and there is always the risk that the Fed may continue raising rates longer than expected. As a result, we continue to prefer securities with better protection against volatility and a slightly shorter duration until we reach that comfortable trading range.

Despite their lackluster performance of late, GNMAs have continued to play an important role in investors’ portfolios. The prepayment and cash flow risks that have recently weighed on prices have not affected the basic stability of GNMAs, which are backed by the full faith and credit of the government. Our goal is to continue to provide a risk-aware approach to shareholders by concentrating investments in those GNMAs that offer the best value, while seeking to invest opportunistically in other types of securities. Generally, we look forward to a more mundane and steady interest rate environment and, hopefully, higher returns.

Thank you for investing with T. Rowe Price.

Respectfully submitted,

Connice A. Bavely
Chairman of the fund’s Investment Advisory Committee

December 16, 2005

The committee chairman has day-to-day responsibility for managing the portfolio and works with committee members in developing and executing the fund’s investment program.

RISKS OF INVESTING IN MORTGAGE-BACKED BONDS

Mortgage securities are subject to interest rate risk: the decline in bond prices that usually accompanies a rise in interest rates, potentially reducing the fund’s income level and share price. Historically, GNMAs and other mortgage-backed bonds have declined less in price when rates were rising because they carry their own special risks, such as prepayment and extension risk. When mortgage rates decline, homeowners usually refinance and prepay principal, causing the average maturity of the portfolio to shorten and reducing the potential for price gains. Extension risk occurs when rates rise, causing the portfolio’s average maturity to lengthen and increasing its sensitivity to interest rate risk and possible price declines.

GLOSSARY

Average maturity: For a bond fund, this is the weighted average of the stated maturity dates of the portfolio’s securities. In general, the longer the average maturity, the greater the fund’s sensitivity to interest rate changes, which can mean greater price fluctuation. A shorter average maturity usually means less interest rate sensitivity, and consequently, a less volatile portfolio.

Basis point: One one-hundredth of one percentage point, or 0.01%.

Call protection: Any of a number of provisions that prohibits a bond’s early redemption for a given period.

Citigroup GNMA Index: A market value-weighted index of 15- and 30-year fixed-rate securities backed by mortgage pools of the Government National Mortgage Association (GNMA).

Collateralized mortgage obligation (CMO): Collateralized mortgage obligations are investment-grade bonds that are backed by mortgage pass-throughs whose cash flows are directed in different ways to different classes. Some classes may have less risk associated with prepayments, and, by default, the other classes will have more prepayment risk. Those classes with less risk generally yield less than other mortgage-backed securities.

Duration: A measure of a bond or bond fund’s sensitivity to changes in interest rates. For example, a fund with a duration of five years would fall about 5% in response to a one-percentage-point rise in rates, and vice versa.

Extension risk: As interest rates rise, the likelihood of prepayment decreases, and the average life and duration of mortgage securities lengthens. Investors are unable to capitalize on higher interest rates because their investment is locked in at a lower rate for a longer period of time.

Implied volatility: A theoretical value designed to represent the volatility of the security underlying an option as determined by the price of the option. It is a representation of the market’s best estimate for future volatility.

Lehman MBS Index: An index that tracks the performance of the mortgage-backed pass-through securities of Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC).

Lehman GNMA Index: An index that tracks the GNMA component of the Lehman MBS Index.

Lipper averages: Consist of all mutual funds in a particular category as tracked by Lipper Inc.

Real interest rate: The excess of the current interest rate over the current inflation rate.

Total return: The annual rate of return on a bond, taking into account interest income, plus appreciation or depreciation. If a bond is held to maturity, its total return equals its yield to maturity.

Yield curve: A graphic depiction of the relationship between yields and maturity dates for a set of similar securities, such as Treasuries or municipal securities. Securities with longer maturities usually have a higher yield. If short-term securities offer a higher yield, then the curve is said to be “inverted.” If short- and long-term bonds are offering equivalent yields, then the curve is said to be “flat.”

GROWTH OF $10,000

This chart shows the value of a hypothetical $10,000 investment in the fund over the past 10 fiscal year periods or since inception (for funds lacking 10-year records). The result is compared with benchmarks, which may include a broad-based market index and a peer group average or index. Market indexes do not include expenses, which are deducted from fund returns as well as mutual fund averages and indexes.

AVERAGE ANNUAL COMPOUND TOTAL RETURN

This table shows how the fund would have performed each year if its actual (or cumulative) returns for the periods shown had been earned at a constant rate.

FUND EXPENSE EXAMPLE

As a mutual fund shareholder, you may incur two types of costs: (1) transaction costs such as redemption fees or sales loads and (2) ongoing costs, including management fees, distribution and service (12b-1) fees, and other fund expenses. The following example is intended to help you understand your ongoing costs (in dollars) of investing in the fund and to compare these costs with the ongoing costs of investing in other mutual funds. The example is based on an investment of $1,000 invested at the beginning of the most recent six-month period and held for the entire period.

Actual Expenses
The first line of the following table (“Actual”) provides information about actual account values and actual expenses. You may use the information in this line, together with your account balance, to estimate the expenses that you paid over the period. Simply divide your account value by $1,000 (for example, an $8,600 account value divided by $1,000 = 8.6), then multiply the result by the number in the first line under the heading “Expenses Paid During Period” to estimate the expenses you paid on your account during this period.

Hypothetical Example for Comparison Purposes
The information on the second line of the table (“Hypothetical”) is based on hypothetical account values and expenses derived from the fund’s actual expense ratio and an assumed 5% per year rate of return before expenses (not the fund’s actual return). You may compare the ongoing costs of investing in the fund with other funds by contrasting this 5% hypothetical example and the 5% hypothetical examples that appear in the shareholder reports of the other funds. The hypothetical account values and expenses may not be used to estimate the actual ending account balance or expenses you paid for the period.

Note: T. Rowe Price charges an annual small-account maintenance fee of $10, generally for accounts with less than $2,000 ($500 for UGMA/UTMA). The fee is waived for any investor whose T. Rowe Price mutual fund accounts total $25,000 or more, accounts employing automatic investing, and IRAs and other retirement plan accounts that utilize a prototype plan sponsored by T. Rowe Price (although a separate custodial or administrative fee may apply to such accounts). This fee is not included in the accompanying table. If you are subject to the fee, keep it in mind when you are estimating the ongoing expenses of investing in the fund and when comparing the expenses of this fund with other funds.

You should also be aware that the expenses shown in the table highlight only your ongoing costs and do not reflect any transaction costs, such as redemption fees or sales loads. Therefore, the second line of the table is useful in comparing ongoing costs only and will not help you determine the relative total costs of owning different funds. To the extent a fund charges transaction costs, however, the total cost of owning that fund is higher.