Annual Report
GNMA Fund
May 31, 1996
T. Rowe Price
REPORT HIGHLIGHTS
o Bond funds have taken a pounding so far in 1996, although the mortgage
sector compiled the best record among high-quality bonds.
o The conditions that contributed to strong bond returns in 1995 changed
direction early in 1996. Yields on long-term securities including GNMAs
rose sharply from their year-end levels.
o Your fund's return was slightly negative during the past six months but
positive over the 12-month period. Performance lagged the benchmark
because of exposure to lower-coupon GNMAs.
o Mortgage prepayments peaked in February, but at a level only 60% of that
reached in late 1993 and early 1994.
o We anticipate a period of relative interest rate stability, which should
be favorable for GNMA securities.
Fellow Shareholders
Bond funds have taken a pounding so far in 1996, although the mortgage sector
in which your fund invests compiled the best record through the end of May.
The initial impetus behind the decline was the failure to reach an accord on a
reasonable approach toward balancing the federal budget. This was followed by
a stronger-than-expected rebound in the economy and a spike in commodity
prices, which triggered inflation fears.
MARKET ENVIRONMENT
Indications of a slowing economy, mild inflation, and easier monetary policy
by the Federal Reserve all contributed to strong returns for bonds in 1995.
These trends changed direction early in 1996, and so did the direction of the
bond market. Long-term Treasury yields rose above 7% from around 6% at
year-end, depressing prices across maturities including the 10-year Treasury
note. GNMA yields paralleled Treasury yields to a great extent, as can be seen
in the accompanying chart.
Chart 1- Yield Comparison
The rate increases of the past five months have subdued prepayment activity,
which can result in losses for investors who purchased mortgage-backed bonds
at prices above par. Prepayments peaked in February, but at a level only 60%
of that reached in late 1993 and early 1994. Sensitivity to rising interest
rates was lower for mortgage-backed securities than for comparable Treasuries.
As a result, the mortgage sector managed to outperform other sectors of the
fixed income market during the past six months.
Considering that rates have risen since the peak in prepayments three months
earlier, it seems likely that the great majority of homeowners who wanted to
refinance their mortgages have already done so - at least at this point in the
cycle. Lower rates give homeowners the opportunity to reduce their monthly
costs and overall interest payments over time. Barring a sudden decline in
interest rates during the months ahead, we expect the pace of prepayments to
remain subdued.
PERFORMANCE REVIEW
Your fund provided a slightly negative return during the six months ended May
31 but managed to generate positive results over the past 12 months, as income
more than offset declining bond prices.
Returns lagged the Lipper benchmark largely because of the portfolio's
exposure to lower-coupon GNMAs, which underperformed higher coupons in recent
months. This exposure was represented both by securities in the portfolio and
in the form of forward contracts, reflected in the Sector Diversification
table following this letter.
PERFORMANCE COMPARISON
Periods Ended 5/31/96 6 Months 12 Months
GNMA Fund - 1.35% 3.72%
Lipper GNMA Funds Average - 0.78 3.94
Our strategy of maintaining a relatively high exposure to lower-coupon GNMAs
was designed for the falling rate environment that prevailed throughout most
of 1995. It was successful then but hindered performance when interest rates
reversed course and began to rise early in 1996.
STRATEGY
As rates rose early this year, we first eliminated the portfolio's 12%
weighting in long-term Treasury bonds, then reestablished the position at a
more modest 6% weighting. We replaced the long Treasuries with higher-coupon
GNMA securities, both to add yield and to reduce the interest rate sensitivity
of the portfolio. We bought GNMA 8% securities and higher coupons in the
forward market.
Our investment decisions continue to emphasize protection of principal and
level of income. The persistent increase in interest rates so far this year
has led us to adopt a strategy focusing on more defensive, higher-coupon
mortgages. However, we believe that a period of more stable rates may lie
ahead as the economy cools from its strong first quarter (and likely second
quarter as well) growth rate. If this turns out to be the case, a strategy
focusing on securities with higher sensitivity to interest rates could once
again be appropriate. Accordingly, we would purchase both long-term Treasury
bonds and lower-coupon GNMAs in an effort to enhance performance.
The average coupon of the mortgage holdings in the fund on May 31 dropped
slightly from six months earlier, as we added new positions in 6.5%, 7%, and
7.5% pools at the end of last year and 8% coupons so far this year.
OUTLOOK
The economy has solid momentum, and the pace of first quarter growth suggests
that the economy is likely to grow at substantially above its trend rate in
the second quarter. The expansion is now five years old. Eventually, some
imbalance could develop, or an external shock could jolt the economy into a
recession. At the moment, however, a contraction appears to be a distant
prospect.
_____________________________________________________________________________
THE ECONOMY IS LIKELY TO GROW AT SUBSTANTIALLY ABOVE ITS TREND RATE IN THE
SECOND QUARTER.
Against this backdrop, there is no immediate urgency for the Fed to move
toward a restrictive mode (although it could tighten down the road) since the
fixed income markets have already responded with higher rates. Higher bond
yields during the past five months may already reflect much of the news about
growth and inflation.
Currently, we anticipate a period of relative interest rate stability compared
with what we have seen during the past few months; this should be favorable
for GNMA securities. In such an environment, the returns from GNMA coupons
could make them attractive choices for fixed income investors.
Thank you for investing with T. Rowe Price.
Respectfully submitted,
Peter Van Dyke
President and
Chairman of the Investment Advisory Committee
June 21, 1996
T. Rowe Price GNMA Fund
PORTFOLIO HIGHLIGHTS
KEY STATISTICS
11/30/95 5/31/96
_____________________________________________________________________________
Price Per Share $ 9.65 $ 9.19
Dividends Per Share
For 6 months 0.34 0.33
For 12 months 0.68 0.67
Dividend Yield *
For 6 months 7.22% 7.04%
For 12 months 7.52 7.26
Weighted Average Maturity (years)** 9.4 7.9
Weighted Average Effective Duration (years) 4.8 5.4
Weighted Average Quality *** AAA AAA
* Dividends earned and reinvested for the periods indicated are annualized
and divided by the average daily net asset values per share for the same
period.
** Based on prepayment-adjusted life of GNMA securities.
*** Based on T. Rowe Price research.
SECTOR DIVERSIFICATION
Percent of Percent of
Net Assets Net Assets
11/30/95 5/31/96
_____________________________________________________________________________
GNMA Securities 97% 103%
U.S. Treasury Obligations 12 6
Other Government Agency Securities 1 1
Other Assets Less Liabilities - 10 - 10
Total 100% 100%
T. Rowe Price GNMA Fund
PERFORMANCE COMPARISON
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 a broad-based average or index.
The index return does not reflect expenses, which have been deducted from the
fund's return.
Chart 2 - SEC graph
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.
Periods Ended 5/31/96 1 Year 3 Years 5 Years 10 Years
_____________________________________________________________________________
GNMA Fund 3.72% 4.90% 7.04% 7.85%
Investment return and principal value represent past performance and will
vary. Shares may be worth more or less at redemption than at original
purchase.
T. Rowe Price GNMA Fund
FINANCIAL HIGHLIGHTS For a share outstanding throughout each period
Year 3 Months! Year
Ended Ended Ended
5/31/96 5/31/95 5/31/94 2/28/94 2/28/93 2/29/92
_____________________________________________________________________________
NET ASSET VALUE
Beginning of
period $ 9.51 $ 9.14 $ 9.60 $ 9.92 $ 9.79 $ 9.47
Investment activities
Net invest-
ment income 0.67 0.68 0.17 0.68 0.75 0.80
Net realized and
unrealized
gain (loss) (0.32) 0.37 (0.46) (0.32) 0.13 0.32
Total from
investment
activities 0.35 1.05 (0.29) 0.36 0.88 1.12
Distributions
Net invest-
ment income (0.67) (0.66) (0.17) (0.68) (0.75) (0.80)
Tax return
of capital - (0.02) - - - -
Total
distributions (0.67) (0.68) (0.17) (0.68) (0.75) (0.80)
NET ASSET VALUE
End of period $ 9.19 $ 9.51 $ 9.14 $ 9.60 $ 9.92 $ 9.79
Ratios/Supplemental Data
Total return 3.72% 12.11% (3.03)% 3.71% 9.36% 12.28%
Ratio of expenses
to average
net assets 0.74% 0.76% 0.76%! 0.77% 0.79% 0.86%
Ratio of net
investment
income to average
net assets 7.04% 7.50% 7.24%! 6.93% 7.65% 8.25%
Portfolio
turnover
rate 113.6% 121.3% 151.8%! 92.5% 94.2% 66.0%
Net assets,
end of
period (in
thousands) $ 903,796 $810,467 $ 802,304 $ 883,391 $913,722 $ 715,249
! Annualized.
! The fund's fiscal year-end was changed to May 31.
The accompanying notes are an integral part of these financial statements.
T. Rowe Price GNMA Fund
May 31, 1996
STATEMENT OF NET ASSETS Par Value
In thousands
U.S. GOVERNMENT MORTGAGE-BACKED SECURITIES 103.9%
U.S. Government Guaranteed Obligations 103.9%
Federal Housing Authority, PLC,
9.95%, 10/1/32 $ 4,973 $ 5,190
Government National Mortgage Assn.
I
6.00%, 12/15/23 - 3/15/26 37,209 33,400
6.50%, 6/15/23 - 5/15/26 57,821 53,480
7.00%, 4/15/17 - 3/15/26 136,749 130,775
7.50%, 3/15/07 - 3/15/26 104,440 103,046
8.00%, 11/15/12 - 3/15/26 190,659 192,683
8.50%, 12/15/04 - 1/15/27 40,763 42,467
9.00%, 4/15/16 - 9/15/24 67,676 71,564
9.50%, 6/15/09 - 5/15/25 31,649 33,833
10.00%, 10/15/15 - 7/15/24 10,757 11,779
10.50%, 1/15/13 - 11/15/21 5,813 6,371
11.00%, 2/15/10 - 6/15/19 1,310 1,453
11.50%, 4/15/10 - 7/15/20 5,214 5,867
12.00%, 5/15/11 - 10/15/15 7,012 8,068
12.50%, 4/15/10 - 7/15/15 2,696 3,128
13.00%, 1/15/11 - 8/15/15 1,238 1,455
13.50%, 5/15/10 - 2/15/15 1,860 2,208
II
6.50%, 3/20/26 8,975 8,223
8.00%, 10/20/24 3,282 3,271
8.50%, 4/20/16 - 2/20/23 25,550 25,975
10.00%, 9/20/16 - 5/20/25 2,985 3,226
11.00%, 2/20/14 - 9/20/20 2,650 2,960
11.50%, 12/20/13 - 7/20/20 1,828 2,067
12.50%, 10/20/13 - 1/20/16 227 263
13.00%, 10/20/13 - 9/20/15 981 1,152
GPM, I
8.75%, 6/15/17 - 6/15/22 1,367 1,430
9.00%, 5/15/09 - 3/15/14 652 683
9.25%, 5/15/16 - 8/15/21 6,822 7,154
9.50%, 6/15 - 11/15/09 2,733 2,921
9.75%, 4/15/16 - 8/15/21 8,032 8,592
10.75%, 2/15/16 - 4/15/19 $ 1,816 $ 2,020
11.00%, 8/15 - 9/15/10 390 437
12.00%, 10/15/10 - 2/15/13 577 667
12.25%, 9/15/13 - 3/15/15 349 404
12.50%, 4/15/10 - 10/15/12 627 728
12.75%, 10/15/13 - 5/15/15 428 501
GPM, II
9.75%, 12/20/20 - 7/20/21 407 433
10.25%, 3/20 - 9/20/16 44 48
11.00%, 9/20/13 - 1/20/14 146 162
12.25%, 1/20/14 - 12/20/15 371 427
12.75%, 10/20/13 - 7/20/15 351 408
PLC, I, 9.25%, 1/15/36 4,139 4,227
Project Loan, I
9.25%, 10/15/23 9,843 10,289
10.00%, 2/15/30 10,872 11,775
10.75%, 3/15/26 6,138 6,714
REMIC
6.50%, 10/16/24 33,000 27,988
Interest Only, 8.00%, 6/16/23 ** 14,189 2,607
TBA, I
6.00%, 9/15/23 30,000 26,929
6.50%, 1/15/24 40,000 36,948
8.00%, 7/15/20 10,000 10,030
8.50%, 7/15/20 20,000 20,483
_____________________________________________________________________________
Total U.S. Government Mortgage-Backed Securities
(Cost $939,615) 938,909
U.S. GOVERNMENT OBLIGATIONS 6.4%
U.S. Treasury Obligations 6.4%
U.S. Treasury Bonds, 6.00%, 2/15/26 23,000 20,158
U.S. Treasury Notes, 6.625%, 3/31/97 37,285 37,541
_____________________________________________________________________________
Total U.S. Government Obligations (Cost $59,017) 57,699
_____________________________________________________________________________
Total Investments in Securities
110.3% of Net Assets (Cost $998,632) $ 996,608
Other Assets Less Liabilities (92,812)
NET ASSETS $ 903,796
Net Assets Consist of:
Accumulated net investment income - net of distributions $ (5,340)
Accumulated net realized gain/loss - net of distributions (26,739)
Net unrealized gain (loss) (2,024)
Paid-in-capital applicable to 98,324,249 no par value
shares of beneficial interest outstanding;
unlimited number of shares authorized 937,899
NET ASSETS $ 903,796
NET ASSET VALUE PER SHARE $ 9.19
** For Interest Only securities, amount represents notional principal,
on which the fund receives interest.
GPM Graduated Payment Mortgage
PLC Permanent Loan Certificate
REMIC Real Estate Mortgage Investment Conduit
TBA To Be Announced security purchased on a forward commitment basis;
the aggregate liability for securities purchased under such
agreements totaled $95,911,000 at 5/31/96.
T. Rowe Price GNMA Fund
STATEMENT OF OPERATIONS
In thousands
Year
Ended
5/31/96
_____________________________________________________________________________
Investment Income
Interest income $ 67,580
Expenses
Investment management 4,223
Shareholder servicing 1,545
Custody and accounting 487
Prospectus and shareholder reports 66
Legal and audit 36
Registration 28
Trustees 12
Miscellaneous 16
Total expenses 6,413
Net investment income 61,167
Realized and Unrealized Gain (Loss)
Net realized gain (loss) on securities (5,065)
Change in net unrealized gain or loss
on securities (27,261)
Net realized and unrealized gain (loss) (32,326)
INCREASE (DECREASE) IN NET
ASSETS FROM OPERATIONS $ 28,841
The accompanying notes are an integral part of these financial statements.
T. Rowe Price GNMA Fund
STATEMENT OF CHANGES IN NET ASSETS
In thousands
Year Year
Ended Ended
5/31/96 5/31/95
_____________________________________________________________________________
Increase (Decrease) in Net Assets
Operations
Net investment income $ 61,167 $ 58,421
Net realized gain (loss) (5,065) (6,992)
Change in net unrealized gain or loss (27,261) 37,254
Increase (decrease) in net assets
from operations 28,841 88,683
Distributions to shareholders
Net investment income (61,156) (56,700)
Tax return of capital - (1,712)
Decrease in net assets from distributions (61,156) (58,412)
Capital share transactions*
Shares sold 245,262 125,225
Distributions reinvested 43,549 45,242
Shares redeemed (163,167) (192,575)
Increase (decrease) in net assets
from capital share transactions 125,644 (22,108)
Net Assets
Increase (decrease) during period 93,329 8,163
Beginning of period 810,467 802,304
End of period $ 903,796 $ 810,467
*Share information
Shares sold 25,637 13,818
Distributions reinvested 4,578 4,981
Shares redeemed (17,153) (21,307)
Increase (decrease) in shares outstanding 13,062 (2,508)
The accompanying notes are an integral part of these financial statements.
T. Rowe Price GNMA Fund
May 31, 1996
NOTES TO FINANCIAL STATEMENTS
Note 1 - Significant Accounting Policies
T. Rowe Price GNMA Fund (the fund) is registered under the Investment Company
Act of 1940 as a diversified, open-end management investment company and
commenced operations on November 26, 1985.
Valuation Debt securities are generally traded in the over-the-counter
market. Investments in securities are stated at fair value as furnished by
dealers who make markets in such securities or by an independent pricing
service, which considers yield or price of bonds of comparable quality,
coupon, maturity, and type, as well as prices quoted by dealers who make
markets in such securities.
Assets and liabilities for which the above valuation procedures are
inappropriate or are deemed not to reflect fair value are stated at fair value
as determined in good faith by or under the supervision of the officers of the
fund, as authorized by the Board of Trustees.
Premiums and Discounts Premiums and discounts on mortgage-backed securities
are recognized upon principal repayment as gain or loss for financial
reporting purposes and as ordinary income for tax purposes. Premiums and
discounts on debt securities, other than mortgage-backed securities, are
amortized for both financial reporting and tax purposes.
Other Income and expenses are recorded on the accrual basis. Investment
transactions are accounted for on the trade date. Realized gains and losses
are reported on the identified cost basis. Distributions to shareholders are
recorded by the fund on the ex-dividend date. Income and capital gain
distributions are determined in accordance with federal income tax regulations
and may differ from those determined in accordance with generally accepted
accounting principles.
Note 2 - Investment Transactions
Consistent with its investment objective, the fund engages in the following
practices to manage exposure to certain risks or enhance performance. The
investment objective, policies, program, and risk factors of the fund are
described more fully in the fund's prospectus and Statement of Additional
Information.
Securities Lending To earn additional income, the fund lends its securities
to approved brokers. At May 31, 1996, the market value of securities on loan
was $19,224,000, which was fully collateralized with cash. Although the risk
is mitigated by the collateral, the fund could experience a delay in
recovering its securities and a possible loss of income or value if the
borrower fails to return them.
Other Purchases and sales of U.S. government securities aggregated
$1,161,501,000 and $1,093,942,000, respectively, for the year ended May 31,
1996.
Note 3 - Federal Income Taxes
No provision for federal income taxes is required since the fund intends to
continue to qualify as a regulated investment company and distribute all of
its taxable income. The fund has unused realized capital loss carryforwards
for federal income tax purposes of $18,542,000, of which $1,432,000 expires in
1997, $1,304,000 in 1998, and $15,806,000 thereafter through 2003. Capital
loss carryforwards utilized in 1996 amounted to $3,504,000. The fund intends
to retain gains realized in future periods that may be offset by available
capital loss carryforwards.
In order for the fund's capital accounts and distributions to shareholders to
reflect the tax character of certain transactions, the following
reclassifications were made during the year ended May 31, 1996. The results of
operations and net assets were not affected by the reclassifications.
Undistributed net investment income $ (577)
Undistributed net realized gain 11,830
Paid-in-capital (11,253)
At May 31, 1996, the aggregate cost of investments for federal income tax and
financial reporting purposes was $998,632,000, and net unrealized loss
aggregated $2,024,000, of which $16,418,000 related to appreciated investments
and $18,442,000 to depreciated investments.
Note 4 - Related Party Transactions
The investment management agreement between the fund and T. Rowe Price
Associates, Inc. (the manager) provides for an annual investment management
fee, of which $372,000 was payable at May 31, 1996. The fee is computed daily
and paid monthly, and consists of an individual fund fee equal to 0.15% of
average daily net assets and a group fee. The group fee is based on the
combined assets of certain mutual funds sponsored by the manager or Rowe
Price-Fleming International, Inc. (the group). The group fee rate ranges from
0.48% for the first $1 billion of assets to 0.305% for assets in excess of $50
billion. At May 31, 1996, and for the year then ended, the effective annual
group fee rate was 0.33% and 0.34%, respectively. The fund pays a pro rata
share of the group fee based on the ratio of its net assets to those of the
group.
In addition, the fund has entered into agreements with the manager and two
wholly owned subsidiaries of the manager, pursuant to which the fund receives
certain other services. The manager computes the daily share price and
maintains the financial records of the fund. T. Rowe Price Services, Inc.
(TRPS) is the fund's transfer and dividend disbursing agent and provides
shareholder and administrative services to the fund. T. Rowe Price Retirement
Plan Services, Inc., provides subaccounting and recordkeeping services for
certain retirement accounts invested in the fund. Additionally, the fund is
one of several T. Rowe Price mutual funds (the underlying funds) in which the
T. Rowe Price Spectrum Income Fund (Spectrum) invests. In accordance with an
agreement among Spectrum, the underlying funds, the manager, and TRPS,
expenses from the operation of Spectrum are borne by the underlying funds
based on each underlying fund's proportionate share of assets owned by
Spectrum. The fund incurred expenses pursuant to these related party
agreements totaling approximately $1,482,000 for the year ended May 31, 1996,
of which $109,000 was payable at period-end.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Trustees and Shareholders of
T. Rowe Price GNMA Fund
In our opinion, the accompanying statement of net assets and the related
statements of operations and of changes in net assets and the financial
highlights present fairly, in all material respects, the financial position of
T. Rowe Price GNMA Fund (the "Fund") at May 31, 1996, and the results of its
operations, the changes in its net assets, and the financial highlights for
each of the fiscal periods presented, in conformity with generally accepted
accounting principles. These financial statements and financial highlights
(hereafter referred to as "financial statements") are the responsibility of
the Fund's management; our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audits of these
financial statements in accordance with generally accepted auditing standards
which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management,
and evaluating the overall financial statement presentation. We believe that
our audits, which included confirmation of securities at May 31, 1996 by
correspondence with the custodian and, where appropriate, the application of
alternative auditing procedures for unsettled security transactions, provide a
reasonable basis for the opinion expressed above.
PRICE WATERHOUSE LLP
Baltimore, Maryland
June 19, 1996
T. ROWE PRICE SHAREHOLDER SERVICES
To help shareholders monitor their current investments and make decisions that
accurately reflect their financial goals, T. Rowe Price offers a wide variety
of information and services - at no extra cost.
Knowledgeable Service Representatives
By Phone 1-800-225-5132 Available Monday through Friday from 8 a.m. to 10
p.m. and weekends from 8:30 a.m. to 5 p.m.
In Person Available in T. Rowe Price Investor Centers.
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Checking Available on most fixed income funds.
Automatic Investing From your bank account or paycheck.
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Distribution Options Reinvest all, some, or none of your distributions.
Automated 24-Hour Services Including Tele*Access(registered trademark) and T.
Rowe Price OnLine.
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Individual Investments Stocks, bonds, options, precious metals, and other
securities; potentially large savings on commissions.
Investment Information
Combined Statement An overview of your T. Rowe Price accounts.
Shareholder Reports Fund managers' reviews of their strategies and results.
The T. Rowe Price Report A quarterly investment newsletter discussing markets
and financial strategies.
Performance Update Quarterly review of all T. Rowe Price fund results.
Insights Educational reports on investment strategies and financial markets.
Investment Guides Asset Mix Worksheet, College Planning Kit, Personal
Strategy Planner, Retirees Financial Guide, and Retirement Planning Kit.
T. ROWE PRICE MUTUAL FUNDS
Stock Funds
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Balanced
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T. Rowe Price No-Load Variable Annuity
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*Closed to new investors.
For yield, price, last transaction,and current balance, 24 hours, 7 days a
week, call: 1-800-638-2587 toll free
For assistance with your existing fund account, call: Shareholder Service
Center 1-800-225-5132 toll free
625-6500 Baltimore area
T. Rowe Price
100 East Pratt Street
Baltimore, Maryland 21202
This report is authorized for distribution only to shareholders and to others
who have received a copy of the prospectus of the T. Rowe Price GNMA Fund.
T. Rowe Price Investment Services, Inc., Distributor RPRTGNMA 5/31/96
Chart 1 - Yield Comparison chart showing current coupon GNMA and 10-year
Treasury note yields from 5/31/95 through 5/31/96.
Chart 2 - SEC Graph - A line chart showing the cumulative growth of $10,000
invested in the GNMA Fund over the past 10 years compared with $10,000
invested in a broad-based average and index over the same period.
