ANNual REPORT May 31, 2017 PRGMX PRXAX T. Rowe Price GNMA Fund GNMA Fund I Class The fund invests for current income through mortgage-backed and other high-quality securities that have negligible credit risk.
HIGHLIGHTS GNMAs and other agency mortgage-backed securities (MBS) produced positive results for the 12-month period but underperformed the broader U.S. investment-grade bond market amid uncertainty about when the Fed would begin reducing its MBS holdings. The GNMA Fund outperformed both its Lipper peer group average and the Bloomberg Barclays U.S. GNMA Index during the 12-month period. Our asset allocation decisions and interest rate management were beneficial for the portfolio, and security selection, supported by our solid fundamental research capabilities, also added value. While the fundamentals of the housing market are solid, the Fed s plan to begin tapering its balance sheet could provide a headwind for the MBS market. The views and opinions in this report were current as of May 31, 2017. 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, 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. REPORTS ON THE WEB Sign up for our Email Program, and you can begin to receive updated fund reports and prospectuses online rather than through the mail. Log in to your account at troweprice.com for more information.
Manager s Letter Fellow Shareholders GNMAs and other agency mortgage-backed securities (MBS) produced positive results for the 12-month period ended May 31, 2017, but underperformed the broader U.S. investment-grade bond market. Fixed income markets experienced a broad sell-off following the U.S. presidential election in November, driving yields higher, but bonds recovered later in the reporting period as investors recalibrated their initial expectations that the Trump administration would be able to quickly implement expansionary fiscal policies. The Federal Reserve continued to reinvest in its MBS holdings, but, soon after our reporting period ended, the central bank announced plans to begin tapering its balance sheet later in 2017. The GNMA Fund returned 1.22% over the 12 months ended May 31, 2017. As shown in the Performance Comparison table, the fund outperformed both the Bloomberg Barclays U.S. GNMA Index Performance Comparison Total Return Periods Ended 5/31/17 6 Months 12 Months GNMA Fund 1.07% 1.22% Bloomberg Barclays U.S. GNMA Index 1.37 0.96 Lipper GNMA Funds Average 1.03 0.65 and the Lipper GNMA Funds Average. Asset allocation was the largest contributor to the fund s outperformance. After modest results in the first half of the fiscal year, nearly all of the fund s gains came in the most recent six months. Economy and Interest Rates After expanding 1.6% in 2016, U.S. gross domestic product growth slowed to a 1.2% annualized pace in the first three months of 2017, according to the Commerce Department s latest estimate. While first-quarter growth was weak, the underlying trend of moderate U.S. economic expansion seems to remain in place, and initial reports 1
What Rising Rates Mean for Bonds With the Federal Reserve expected to continue its measured approach to interest rate hikes, yields on U.S. Treasuries and other fixed income securities have slowly increased from the low levels of the recent past. We expect the Fed to pause after each increase in the federal funds rate and to carefully analyze incoming U.S. economic data to be sure that economic activity is strong enough to withstand further incremental moves toward normalization of monetary policy. The Fed s more gradual approach to interest rate increases than in previous cycles nonetheless brings the risk of rising rates to the forefront for bond investors. Higher interest rates weigh on the prices of most types of bonds. Importantly, investors also need to understand that not all bonds or bond funds respond uniformly in such an environment. In particular, the duration of a bond or bond fund, which is tied in part to its maturity, provides important information about how the asset will perform when rates change. Also, some bond sectors and bonds of varying quality are better insulated from rate changes and may even perform well as rates rise. A bond fund s duration (shown in the Portfolio Characteristics exhibit) is the most precise indicator of how the fund will respond to rising rates. If a bond fund has a duration of 5.3 years, for example, the fund s net asset value (NAV) would be expected to fall about 5.3% for every one-percentage-point rise in rates. Even this is only part of the picture, however rising rates will also generally mean higher dividends per share as the fund invests in new, higher-yielding bonds. As a result, the fund s total return (change in NAV plus dividend income) is unlikely to fall as steeply as the duration indicates. Generally, bond funds with a shorter weighted average maturity in other words, those with holdings that come due sooner have lower durations and should fare better than funds with longer average maturities when rates rise. This is because investors in the bonds will not be locked into lower yields, or coupon payments, for long. When the fund receives principal payments from maturing bonds, it can reinvest them at a higher yield. Indeed, for investors in a bond fund with a low duration and a low weighted average maturity, higher rates can mean an increase in income potential. Some fixed income sectors offer an added degree of protection from rising rates. Floating rate funds invest in bank loans where the interest rate on the loan is periodically reset, meaning that investors face very little interest rate risk. However, the bank loans usually have a credit profile that is below investment quality, which means these investments may have greater exposure to default risk than investment-grade bonds. Mortgage-backed securities typically fare better than other bonds of similar maturity when rates rise modestly, as fewer homeowners will refinance and pay off their loans early. In addition, lower-quality bonds with a price that is highly sensitive to the issuer s credit rating (shown in the Quality Diversification exhibit) may perform better as rates increase. Rising rates often accompany a strengthening economy, which can lead to credit upgrades for lower-rated issuers. Also, the higher yields offered by lower-quality bonds provide an additional cushion to total return if bond prices fall as interest rates increase. However, lower-quality bonds are generally exposed to greater credit risk than other bonds because the securities carry a higher risk of default. 2
2.0 1.5 1.0 0.5 0.0 Interest Rate Levels 4.0% Current Coupon GNMA 10-Year Treasury Note 3.5 3.0 2.5 5/31/16 8/16 11/16 2/17 5/31/17 Sources: Bloomberg Barclays and the Federal Reserve Board. indicate that a rebound is likely in the second quarter. Housing market data remained solid, as the percentage of delinquent or foreclosed loans has been trending lower. Although the pace of employment growth has moderated compared with the last few years, the labor market remains strong. The unemployment rate fell from 4.7% at the start of the reporting period to 4.3% in May, the lowest level in 16 years, although wage increases have slowed somewhat. Employers added an average of 189,000 new jobs a month for the 12-month period. The annual inflation rate reached a five-year high of 2.7% in February before trailing off in the following months, and any further increases are likely to be gradual as energy prices level off. Citing an improving labor market and rising inflation, the Federal Reserve raised interest rates twice during our reporting period and once more on June 14, soon after our reporting period ended. After signaling to financial markets for several months that the case for raising short-term rates had strengthened, Fed officials lifted the federal funds rate 25 basis points in December and followed with additional 25-basis-point increases in March and June. After the series of hikes, the target range for the fed funds rate was 1.00% to 1.25%. The central bank maintained its policy of reinvesting principal payments from its MBS holdings during our reporting period, which has been supportive of the sector, but at its June meeting the Fed said it will begin gradually reducing its balance sheet by the end of this year if economic conditions remain favorable. Treasury yields across all maturities were higher at the end of May than they were 12 months earlier, with the yield of the 10-year note which best approximates the maturity of GNMAs and other MBS rising from 1.84% to 2.21%. The Treasury yield curve flattened during the period as shorter maturities, which are more directly affected by Fed rate increases, rose more than longer-maturity bonds, which are more sensitive to fluctuations in inflation expectations. 3
Yields declined early in the period, with the 10-year Treasury note hitting a record-low yield of 1.36% in early July, following concerns about slowing global growth and the UK s vote to leave the European Union. Yields later began rising on speculation that the European Central Bank would begin tapering its asset purchases and expectations that the Fed would proceed with rate hikes given stronger economic data. The Treasury sell-off intensified following the U.S. election as the market priced in the possibility of higher growth, inflation, and debt levels under a Trump administration; as a result, November was the worst month for Treasuries since January 2009. The yield for the 10-year note reached 2.62% its high point for the period in mid-march. However, investor demand for Treasuries increased, and yields started to trend lower as a series of political developments, including the initial failure of the Republican effort to replace the Affordable Care Act, sparked doubts about how quickly the Trump administration would be able to implement its potentially inflationary economic agenda. Portfolio Review Portfolio Characteristics Periods Ended 11/30/16 5/31/17 GNMA Fund Share Price $9.35 $9.32 Dividends Per Share For 6 Months 0.14 0.13 For 12 Months 0.27 0.26 SEC Yield (30-day) 1.49% 2.03% GNMA Fund I Class Share Price $9.32 Dividends Per Share Since Inception 5/3/17 0.02 SEC Yield (30-day) Weighted Average Maturity (years) 7.6 6.7 Weighted Average Effective Duration (years) 4.3 4.7 12-month dividends may not equal the combined 6-month figures due to rounding. It was a challenging year for the MBS market. Concerns about prepayment risk amid the falling rate environment early in our fiscal year were replaced by fears of rising exposure to interest rate risk as expectations for fiscal stimulus following the election led to higher long-term rates. We took a risk-aware approach in positioning the portfolio during this environment, which helped the fund outperform its benchmark and Lipper peer group average. (Performance for the I Class will vary due to its differing fee structure.) 4
Investing in GNMAs GNMAs, also known as Ginnie Maes, are a popular investment option because they offer government backing along with the potential for higher yields. GNMA bonds are MBS guaranteed by the Government National Mortgage Association, a wholly government-owned corporation established in 1968 and overseen by the Department of Housing and Urban Development. GNMAs, like Treasuries, are backed by the full faith and credit of the U.S. government. While they share the high-quality credit profile of Treasuries, GNMAs perform somewhat differently for investors. Most notably, GNMAs carry prepayment risk, or the risk that the underlying home mortgages will be refinanced and repaid if interest rates decline. Holders of Treasuries and other bonds that cannot be repaid early (or noncallable bonds) see the value of their bonds rise as interest rates fall. While holders of GNMAs may see some benefit from falling rates, they may also receive a portion of their investment back, forcing them to reinvest at lower interest rates. The risk of prepayment is one reason GNMAs and MBS generally offer higher yields than Treasuries with comparable maturities. Two government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, also sponsor MBS. These GSEs, known as agencies, have private stockholders but were placed under government conservatorship in 2008. As a result, bonds issued by Fannie Mae and Freddie Mac (known as agency MBS) do not have the full faith and credit backing of the U.S. government, although they are considered very secure. Banks and other nongovernmental institutions may offer riskier private label MBS as well as CMBS, securities based on commercial real estate mortgages. Agency MBS typically represent the largest sector of the investment-grade bond market, making them attractive for their liquidity the ease with which they can be bought and sold. Asset allocation was the largest contributor to relative outperformance, and our out-of-benchmark position in collateralized mortgage obligations (CMOs) was particularly beneficial. We added to our holdings in this subsector of the mortgage market in the first half of our fiscal year and targeted our purchases Security Diversification toward floating rate structures. Floating rate CMOs GNMA Mortgage-Backed Securities 86% are less sensitive to interest Agency Mortgage-Backed Securities 10 rate movements and Collateralized Mortgage Obligations 4 outperformed when rates U.S. Treasuries 4 moved higher. CMOs made up 10% of the portfolio at Asset-Backed Securities 3 the end of November, but Interest Only/Principal Only 1 we subsequently trimmed All Other -8 our position to 4% by Total 100% the end of the reporting Based on net assets as of 5/31/17. period as the need for protection against higher rates diminished. 5
GNMAs continued to make up the largest portion of the fund s assets, but we reduced our position from 94% of net assets to 86% during the past 12 months. We were underweight the benchmark during the period, which helped relative results. We believed the valuations of these securities had Quality Diversification U.S. Government Agency Securities* 101% U.S. Treasury Securities** 4 AAA 2 AA 1 Reserves -8 Total 100% Based on net assets as of 5/31/17. *U.S. government agency securities are issued or guaranteed by a U.S. government agency and may include conventional pass-through securities and collateralized mortgage obligations; unlike Treasuries, government agency securities are not issued directly by the U.S. government and are generally unrated but may have credit support from the U.S. Treasury (e.g., FHLMC and FNMA issues) or a direct government guarantee (e.g., GNMA issues). Therefore, this category may include rated and unrated securities. **U.S. Treasury securities are issued by the U.S. Treasury and are backed by the full faith and credit of the U.S. government. The ratings of U.S. Treasury securities are derived from the ratings on the U.S. government. Sources: Moody s Investors Service; if Moody s does not rate a security, then Standard & Poor s (S&P) is used as a secondary source. When available, T. Rowe Price will use Fitch for securities that are not rated by Moody s or S&P. T. Rowe Price does not evaluate these ratings but simply assigns them to the appropriate credit quality category as determined by the rating agency. Securities that have not been rated by any rating agency totaled -0.02% of the portfolio at the end of the reporting period. The negative percentage of not rated securities is attributable to derivative holdings. become unattractive as a result of heavy demand from overseas investors searching for yield. We also benefited from our positioning within GNMAs. We favored holding liquid 30-year to-be-announced (TBA) GNMAs and had some exposure to loans originated with a smaller balance. Our position in pools of loans originated earlier in this economic cycle provided a greater source of income to our shareholders. Our small position in asset-backed securities also added value as these short-duration, highquality assets performed well during the period. The fund s yield curve positioning contributed to relative results. In this low-yield environment, we maintained a longer duration than the index during most of the year but made adjustments with the use of interest rate derivatives along the way to preserve income and lower the risks that the portfolio faced from uncertainty in the market. During the 12-month period, our derivatives positions had a positive impact on performance. 6
Outlook The Federal Reserve s announcement that it expects to begin reducing its MBS holdings later this year could be a headwind for the MBS sector as the market seeks to absorb the additional supply from the central bank. Although the Fed provided some details of its plan for balance sheet normalization in its June 14 statement, uncertainties remain about other details that could have an impact on the market, such as the start date of the program and the terminal size of the balance sheet. Other risks, such as the potential reform of government-sponsored enterprises, are also present. Although the Fed s actions could provide technical challenges, the fundamentals of the housing market appear solid, providing support for the sector. Moreover, the liquidity and strong credit quality of agency MBS should remain appealing to fixed income investors, and MBS appear attractive relative to other credit-sensitive sectors. We structure the portfolio to provide shareholders with the most attractive low-risk opportunities in the market, and we believe we are well positioned for the potential volatility that the sector could face. Balancing the cost of liquidity against risk level is an integral part of our investment and risk-monitoring process. Our management team also uses internally and externally developed quantitative tools to track and manage the risk profile of the portfolio as market conditions change. Security selection is still critical, and we will continue to rely heavily on our extensive team of analysts, who provide careful, fundamental research on individual bonds. As always, thank you for investing with T. Rowe Price. Respectfully submitted, Andrew McCormick Chairman of the fund s Investment Advisory Committee June 19, 2017 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. 7
Risk of GNMA Fund Investing Even though principal and interest payments on GNMAs are guaranteed, an increase in interest rates can cause the share price to decline, resulting in a loss of principal. Investors in bond funds are also subject to several other types of risk interest rate risk, credit risk, prepayment risk, extension risk, and derivatives risk. Since the fund invests primarily in GNMAs, which are backed by the full faith and credit of the U.S. government, its exposure to credit risk is low. A mortgage-backed bond, unlike most other bonds, can be hurt when interest rates fall because homeowners tend to refinance and prepay principal. Prepayments can cause the average maturity of the portfolio to shorten, require the fund to reinvest proceeds at lower interest rates, or even cause certain bonds prices to fall below what the fund paid for them, resulting in a capital loss. Increased interest rates can cause the fund s average maturity to lengthen unexpectedly due to a drop in mortgage prepayments. Shareholders are also exposed to derivatives risk, the potential that our investments in these complex and volatile instruments could affect the fund s share price. Glossary Asset-backed securities: Bonds whose payments are backed by a pool of receivables or other financial assets. Bloomberg Barclays U.S. GNMA Index: Tracks the performance of mortgage-backed pass-through securities of the Government National Mortgage Association (GNMA). Collateralized mortgage obligation: Bonds 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. Commercial mortgage-backed securities (CMBS): Bonds backed by loans on commercial rather than residential properties. Duration: A measure of a bond fund s sensitivity to changes in interest rates. For example, a fund with a duration of five years would fall about 5% in price in response to a onepercentage-point rise in interest rates, and vice versa. Federal funds rate: The interest rate charged on overnight loans of reserves by one financial institution to another in the U.S. The Federal Reserve sets a target federal funds rate to affect the level and direction of market rates. Gross domestic product: The total market value of all goods and services produced in a country in a given year. Lipper averages: The averages of available mutual fund performance returns for specified time periods in categories defined by Lipper Inc. 8
Glossary (continued) SEC yield (30-day): A method of calculating a fund s yield that assumes all portfolio securities are held until maturity. Yield will vary and is not guaranteed. 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. Weighted average maturity: A measure of a fund s interest rate sensitivity. In general, the longer the average maturity, the greater the fund s sensitivity to interest rate changes. The weighted average maturity may take into account the interest rate readjustment dates for certain securities. Money funds must maintain a weighted average maturity of less than 60 days. Yield curve: A graphic depiction of the relationship between yields and maturity dates for a set of similar securities. A security with a longer maturity usually has a higher yield. If a short-term security offers a higher yield, then the curve is said to be inverted. If shortand long-term bonds are offering equivalent yields, then the curve is said to be flat. Note: Bloomberg Index Services Ltd. Copyright 2017, Bloomberg Index Services Ltd. Used with permission. 9
Performance and Expenses 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. GNMA FUND $20,000 18,000 16,000 14,000 12,000 10,000 As of 5/31/17 GNMA Fund $14,714 Bloomberg Barclays U.S. GNMA Index $15,301 Lipper GNMA Funds Average $14,759 5/07 5/08 5/09 5/10 5/11 5/12 5/13 5/14 5/15 5/16 5/17 Note: Performance for the I Class will vary due to its differing fee structure. See returns table below. Average Annual Compound Total Return Since Inception Periods Ended 5/31/17 1 Year 5 Years 10 Years Inception Date GNMA Fund 1.22% 1.57% 3.94% GNMA Fund I Class 0.45% 5/3/17 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. Returns do not reflect taxes that the shareholder may pay on fund distributions or the redemption of fund shares. Past performance cannot guarantee future results. 10
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. Please note that the fund has two share classes: The original share class (Investor Class) charges no distribution and service (12b-1) fee, and the I Class shares are also available to institutionally oriented clients and impose no 12b-1 or administrative fee payment. Each share class is presented separately in the table. Actual Expenses The first line of the following table (Actual) provides information about actual account values and expenses based on the fund s actual returns. You may use the information on 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 on 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 account service fee of $20, generally for accounts with less than $10,000. The fee is waived for any investor whose T. Rowe Price mutual fund accounts total $50,000 or more; accounts electing to receive electronic delivery of account statements, transaction confirmations, prospectuses, and shareholder reports; or accounts of an investor who is a T. Rowe Price Personal Services or Enhanced Personal Services client (enrollment in these programs generally requires T. Rowe Price assets of at least $250,000). 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. 11
Fund Expense Example (continued) GNMA Fund Beginning Ending Expenses Paid Account Value Account Value During Period 12/1/16 5/31/17 12/1/16 to 5/31/17 1 Investor Class Actual $1,000.00 $1,010.70 $2.96 Hypothetical (assumes 5% return before expenses) 1,000.00 1,021.99 2.97 5/4/17 to 5/4/17 2 5/31/17 5/31/17 2,3 I Class Actual $1,000.00 $1,004.50 $0.38 12/1/16 to 12/1/16 2 5/31/17 5/31/17 2,4 Hypothetical (assumes 5% return before expenses) 1,000.00 1,022.49 2.47 1 Expenses are equal to the fund s annualized expense ratio for the 6-month period (0.59%), multiplied by the average account value over the period, multiplied by the number of days in the most recent fiscal half year (182), and divided by the days in the year (365) to reflect the half-year period. 2 The actual expense example is based on the period since the class s start of operations on 5/4/2017, one day after inception; the hypothetical expense example is based on the half-year period beginning 12/1/16, as required by the SEC. 3 Expenses are equal to the class s annualized expense ratio for the period, multiplied by the average account value over the period, multiplied by the number of days in the period (28), and divided by the days in the year (365) to reflect the period since the class s start of operations. The annualized expense ratio of the I Class was 0.49%. 4 Expenses are equal to the class s annualized expense ratio for the period, multiplied by the average account value over the period, multiplied by the number of days in the most recent fiscal half year (182), and divided by the days in the year (365) to reflect the half-year period. The annualized expense ratio of the I Class was 0.49%. 12
Quarter-End Returns Periods Ended 3/31/17 1 Year 5 Years 10 Years GNMA Fund 0.60% 1.59% 3.84% Current performance may be higher or lower than the quoted past performance, which cannot guarantee future results. Share price, principal value, and return will vary, and you may have a gain or loss when you sell your shares. For the most recent month-end performance, please visit our website (troweprice.com) or contact a T. Rowe Price representative at 1-800-225-5132 or, for I Class shares, 1-800-638-8790. This table provides returns net of expenses through the most recent calendar quarter-end rather than through the end of the fund s fiscal period. It 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. Average annual total return figures include changes in principal value, reinvested dividends, and capital gain distributions. Returns do not reflect taxes that the shareholder may pay on fund distributions or the redemption of fund shares. When assessing performance, investors should consider both short- and long-term returns. Expense Ratio GNMA Fund 0.59% GNMA Fund I Class 0.50 The expense ratio shown is as of the fund s fiscal year ended 5/1/17. The expense ratio for the GNMA Fund I Class is estimated as of the class s inception date of 5/3/17. This number may vary from the expense ratio shown elsewhere in this report because it is based on a different time period and, if applicable, includes acquired fund fees and expenses but does not include fee or expense waivers. 13
Financial Highlights For a share outstanding throughout each period Investor Class Year Ended 5/31/17 5/31/16 5/31/15 5/31/14 5/31/13 NET ASSET VALUE Beginning of period $ 9.47 $ 9.60 $ 9.65 $ 9.76 $ 10.12 Investment activities Net investment income (1) 0.15 0.17 0.19 0.20 0.12 Net realized and unrealized gain / loss (0.04) (0.02) 0.05 0.01 (0.09) Total from investment activities 0.11 0.15 0.24 0.21 0.03 Distributions Net investment income (0.26) (0.28) (0.29) (0.32) (0.39) Net realized gain (2) Total distributions (0.26) (0.28) (0.29) (0.32) (0.39) NET ASSET VALUE End of period $ 9.32 $ 9.47 $ 9.60 $ 9.65 $ 9.76 Ratios/Supplemental Data Total return (3) 1.22% 1.63% 2.52% 2.25% 0.24% Ratio of total expenses to average net assets 0.59% 0.59% 0.59% 0.61% 0.59% Ratio of net investment income to average net assets 1.56% 1.84% 1.92% 2.12% 1.24% (4) 14
Financial Highlights For a share outstanding throughout each period Year Ended 5/31/17 5/31/16 5/31/15 5/31/14 5/31/13 Ratios/Supplemental Data (continued) Portfolio turnover rate (5) 429.2% 467.3% 430.0% 261.0% 217.2% Portfolio turnover rate, excluding mortgage dollar roll transactions 189.8% 213.7% 173.6% 78.8% 82.8% Net assets, end of period (in millions) $ 1,457 $ 1,557 $ 1,587 $ 1,662 $ 1,725 (1) Per share amounts calculated using average shares outstanding method. (2) Amounts round to less than $0.01 per share. (3) Total return reflects the rate that an investor would have earned on an investment in the fund during each period, assuming reinvestment of all distributions. (4) Includes the effect of correcting interest income related to stripped mortgage-backed securities (0.41% of average net assets); excluding the effect, the net investment income ratio for the period would have been 1.65%. (5) The portfolio turnover rate calculation includes purchases and sales from the mortgage dollar roll transactions (see Note 4). The accompanying notes are an integral part of these financial statements. 15
Financial Highlights For a share outstanding throughout the period I Class 5/3/17 (1) Through 5/31/17 NET ASSET VALUE Beginning of period $ 9.30 Investment activities Net investment income (2) 0.01 (3) Net realized and unrealized gain / loss 0.03 (4) Total from investment activities 0.04 Distributions Net investment income (0.02) NET ASSET VALUE End of period $ 9.32 Ratios/Supplemental Data Total return (5) 0.45% (3) Ratio of total expenses to average net assets 0.49% (3)(6) Ratio of net investment income to average net assets 1.79% (3)(6) Portfolio turnover rate (7) 429.2% Portfolio turnover rate, excluding mortgage dollar rate transactions 189.8% Net assets, end of period (in thousands) $ 251 (1) Inception date (2) Per share amounts calculated using average shares outstanding method. (3) See Note 6. Excludes expenses waived (0.24% of average net assets) related to the contractual operating expense limitation in effect through September 30, 2019. (4) The amount presented is inconsistent with the fund's aggregate gains and losses because of the timing of sales and redemptions of fund shares in relation to fluctuating market values for the investment portfolio. (5) Total return reflects the rate that an investor would have earned on an investment in the fund during each period, assuming reinvestment of all distributions. Total return is not annualized for periods less than one year. (6) Annualized (7) The portfolio turnover rate calculation includes purchases and sales from the mortgage dollar roll transactions (see Note 4). The accompanying notes are an integral part of these financial statements. 16
May 31, 2017 Portfolio of Investments Par/Shares $ Value (Amounts in 000s) ASSET-BACKED SECURITIES 3.1% Auto Backed 2.1% AmeriCredit Automobile Receivables Trust Series 2014-3, Class D 3.13%, 10/8/20 3,000 3,050 Avis Budget Rental Car Funding Series 2013-2A, Class A 2.97%, 2/20/20 (1) 9,575 9,698 Avis Budget Rental Car Funding Series 2014-1A, Class A 2.46%, 7/20/20 (1) 1,500 1,506 Capital Auto Receivables Asset Trust Series 2015-2, Class B 2.29%, 5/20/20 5,000 5,031 Enterprise Fleet Financing Series 2017-1, Class A2 2.13%, 7/20/22 (1) 4,200 4,214 GMF Floorplan Owner Revolving Trust Series 2017-1, Class B 2.58%, 1/18/22 (1) 7,270 7,290 Other Asset-Backed Securities 0.5% 30,789 ALM Loan Funding Series 2014-14A, Class A1R, CLO, VR 2.322%, 7/28/26 (1) 1,020 1,020 ALM Loan Funding Series 2014-14A, Class A2R, CLO, VR 2.722%, 7/28/26 (1) 1,145 1,145 Madison Park Funding Series 2014-14A, Class A2R, CLO, VR 2.276%, 7/20/26 (1) 2,515 2,518 OZLM Series 2014-8A, Class A1AR, CLO, VR 2.00%, 10/17/26 (1) 2,295 2,295 6,978 17
(Amounts in 000s) Student Loan 0.5% Par/Shares $ Value SMB Private Education Loan Trust Series 2014-A, Class A2A 3.05%, 5/15/26 (1) 2,842 2,897 SMB Private Education Loan Trust Series 2014-A, Class A2B, VR 2.139%, 5/15/26 (1) 3,789 3,830 6,727 Total Asset-Backed Securities (Cost $44,449) 44,494 NON-U.S. GOVERNMENT MORTGAGE-BACKED SECURITIES 0.0% Whole Loans Backed 0.0% Wells Fargo Mortgage Backed Securities Trust Series 2003-O, Class 5A1, CMO, ARM 2.898%, 1/25/34 141 144 Wells Fargo Mortgage Backed Securities Trust Series 2004-G, Class A3, CMO, ARM 3.186%, 6/25/34 199 199 Total Non-U.S. Government Mortgage-Backed Securities (Cost $129) 343 U.S. GOVERNMENT & AGENCY MORTGAGE-BACKED SECURITIES 101.7% U.S. Government Agency Obligations 12.2%(2) Federal Home Loan Mortgage 3.00%, 12/1/42-11/1/46 32,830 33,028 6.50%, 8/1/36 55 62 7.00%, 11/1/30-4/1/32 1,018 1,187 Federal Home Loan Mortgage, CMO, ARM, 1.439%, 10/15/46 15,657 15,643 Federal National Mortgage Assn. 3.00%, 9/1/42-8/1/46 65,415 65,910 3.50%, 9/1/42-4/1/47 47,649 49,345 Federal National Mortgage Assn., ARM, 3.067%, 11/1/35 17 18 18
(Amounts in 000s) Par/Shares $ Value Federal National Mortgage Assn., CMO, 5.50%, 12/25/36 1,755 1,962 Federal National Mortgage Assn., CMO, ARM, 1.474%, 10/25/42 10,555 10,618 Federal National Mortgage Assn., CMO, IO, 8.50%, 4/25/22 2 U.S. Department of Veterans Affairs, Vendee Mortgage Trust CMO, ARM, 9.742%, 3/15/25 8 8 U.S. Government Obligations 89.5% 177,781 Government National Mortgage Assn. 2.50%, 11/20/42-1/20/45 26,000 25,740 3.00%, 8/15/42-1/15/47 197,426 201,544 3.50%, 12/20/40-11/20/46 263,868 276,161 4.00%, 8/20/39-5/20/46 192,580 204,451 4.50%, 11/15/33-2/20/47 130,840 141,164 4.50%, 5/20/40 (3) 20,565 22,245 5.00%, 10/15/17-12/20/45 65,187 72,005 5.50%, 1/15/29-3/20/44 44,146 49,747 6.00%, 6/15/17-10/20/39 10,481 11,926 6.50%, 12/15/23-10/15/36 3,325 3,781 7.00%, 4/15/23-8/15/35 3,169 3,494 7.50%, 7/15/17-6/15/32 1,879 2,088 8.00%, 6/15/17-3/15/30 787 867 8.50%, 7/15/17-3/15/27 89 95 9.00%, 5/15/18-3/20/25 78 83 9.25%, 11/15-12/15/19 17 17 9.50%, 4/15/19-12/15/24 63 67 9.75%, 2/15/21 21 21 10.00%, 12/15/17-3/15/26 64 67 10.50%, 10/15/17-8/15/20 7 8 11.00%, 11/20/18-9/20/19 2 2 19
(Amounts in 000s) Par/Shares $ Value Government National Mortgage Assn., CMO 3.50%, 9/20/41 1,900 1,976 4.00%, 6/20/39-7/20/41 11,203 12,028 4.50%, 9/20/38 1,644 1,697 Government National Mortgage Assn., CMO, ARM 1.43%, 7/20/46 12,053 12,095 Government National Mortgage Assn., CMO, IO 3.00%, 6/20/37 3,495 398 3.50%, 9/20/29-4/20/46 113,224 14,240 4.00%, 5/20/37-2/20/39 21,900 1,325 4.50%, 9/20/37-4/20/39 22,084 715 Government National Mortgage Assn., TBA 3.00%, 1/1/43 34,520 35,150 3.50%, 1/1/42 102,330 106,703 4.00%, 1/1/41 80,055 84,702 4.50%, 1/1/39 16,410 17,557 1,304,159 Total U.S. Government & Agency Mortgage-Backed Securities (Cost $1,480,634) 1,481,940 U.S. GOVERNMENT AGENCY OBLIGATIONS (EXCLUDING MORTGAGE-BACKED) 3.8% U.S. Treasury Obligations 3.8% U.S. Treasury Bonds, 3.00%, 5/15/47 110 113 U.S. Treasury Bonds, 4.75%, 2/15/37 1,560 2,083 U.S. Treasury Inflation-Indexed Notes, 0.375%, 1/15/27 23,162 23,137 U.S. Treasury Notes, 1.25%, 5/31/19 15,760 15,748 U.S. Treasury Notes, 1.875%, 4/30/22 4,730 4,755 U.S. Treasury Notes, 2.375%, 5/15/27 9,170 9,306 Total U.S. Government Agency Obligations (Excluding Mortgage-Backed) (Cost $54,766) 55,142 20
(Amounts in 000s) SHORT-TERM INVESTMENTS 0.2% Money Market Funds 0.2% Par/Shares $ Value T. Rowe Price Government Reserve Fund, 0.83% (4)(5) 3,683 3,683 Total Short-Term Investments (Cost $3,683) 3,683 Total Investments in Securities 108.8% of Net Assets (Cost $1,583,661) $ 1,585,602 Par/Shares are denominated in U.S. dollars unless otherwise noted. (1) Security was purchased pursuant to Rule 144A under the Securities Act of 1933 and may be resold in transactions exempt from registration only to qualified institutional buyers -- total value of such securities at period-end amounts to $36,413 and represents 2.5% of net assets. (2) Issuer operates under a Congressional charter; its securities are neither issued nor guaranteed by the U.S. government. The Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation currently operate under a federal conservatorship. (3) At May 31, 2017, all or a portion of this security is pledged as collateral and/or margin deposit to cover future funding obligations. (4) Seven-day yield (5) Affiliated Company (6) The issuer currently operates under a federal conservatorship; however, its securities are neither issued nor guaranteed by the U.S. government. ARM Adjustable Rate Mortgage CLO Collateralized Loan Obligation CMO Collateralized Mortgage Obligation IO Interest Only security for which the fund receives interest on notional principal TBA To Be Announced purchase commitment; TBAs totaled $244,122 (16.8% of net assets) at period-end - see Note 4. VR Variable Rate; rate shown is effective rate at period-end. 21
(Amounts in 000s) TBA SALES COMMITMENTS (0.5)% U.S. GOVERNMENT & AGENCY MORTGAGE-BACKED SECURITIES (0.5)% Par/Shares $ Value U.S. Government Agency Obligations (0.1)% (6) Federal National Mortgage Assn., 3.50%, 1/1/41 1,585 (1,636) (1,636) U.S. Government Obligations (0.4)% Government National Mortgage Assn., 2.50%, 1/1/43 5,110 (5,028) (5,028) Total TBA Sales Commitments (Proceeds $(6,601)) (6,664) 22
(Amounts in 000s) SWAPS 0.0% Notional Amount Market Value Initial Value Unrealized Gain (Loss) CENTRALLY CLEARED SWAPS 0.0% Interest Rate Swaps 0.0% 2 Year Interest Rate Swap, Pay Fixed 1.528% Receive Variable 1.198%, 3-Month LIBOR, 5/30/19 22,150$ (6)$ 1$ (7) 2 Year Interest Rate Swap, Receive Fixed 1.658% Pay Variable 1.093%, 3-Month LIBOR, 3/6/19 22,150 96 1 95 2 Year Interest Rate Swap, Receive Fixed 1.665% Pay Variable 1.10%, 3-Month LIBOR, 3/7/19 66,250 293 293 30 Year Interest Rate Swap, Pay Fixed 2.594% Receive Variable 1.184%, 3-Month LIBOR, 2/10/47 3,500 (154) (154) 30 Year Interest Rate Swap, Pay Fixed 2.669% Receive Variable 1.119%, 3-Month LIBOR, 12/13/46 15,000 (948) (948) 5 Year Interest Rate Swap, Receive Fixed 2.002% Pay Variable 1.171%, 3-Month LIBOR, 5/8/22 51,500 462 462 Total Centrally Cleared Interest Rate Swaps (259) Total Centrally Cleared Swaps (259) Net Payments (Receipts) of Variation Margin to Date 91 Variation Margin Receivable (Payable) on Centrally Cleared Swaps $ (168) 23
Futures Contracts ($000s) Expiration Contract Value Unrealized Gain (Loss) Short, 259 U.S. Treasury Notes five year contracts 9/17 $ (30,643) $ (4) Long, 88 U.S. Treasury Notes ten year contracts 9/17 11,114 35 Long, 218 U.S. Treasury Notes two year contracts 9/17 47,194 20 Long, 10 Ultra U.S. Treasury Notes ten year contracts 9/17 1,357 Net payments (receipts) of variation margin to date (77) Variation margin receivable (payable) on open futures contracts $ (26) 24
Affiliated Companies ($000s) The fund may invest in certain securities that are considered affiliated companies. As defined by the 1940 Act, an affiliated company is one in which the fund owns 5% or more of the outstanding voting securities, or a company which is under common ownership or control. The following securities were considered affiliated companies for all or some portion of the year ended May 31, 2017. Purchase and sales cost and investment income reflect all activity for the period then ended. Affiliate Purchase Cost Sales Cost Investment Income Value 5/31/17 Value 5/31/16 T. Rowe Price Government Reserve Fund + $ 109 $ 3,683 $ 96,710 Totals $ 109 $ 3,683 $ 96,710 + At May 31, 2016, the underlying fund s name was T. Rowe Price Reserve Investment Fund. Purchase and sale information not shown for cash management funds. Amounts reflected on the accompanying financial statements include the following amounts related to affiliated companies: Investment in securities, at cost $ 3,683 Dividend income 109 Interest income - Investment income $ 109 Realized gain (loss) on securities $ - Capital gain distributions from mutual funds $ - The accompanying notes are an integral part of these financial statements. 25
May 31, 2017 Statement of Assets and Liabilities ($000s, except shares and per share amounts) Assets Investments in securities, at value (cost $1,583,661) $ 1,585,602 Receivable for investment securities sold 332,886 Interest receivable 4,817 Receivable for shares sold 2,375 Cash deposits on centrally cleared swaps 1,144 Restricted cash pledged for TBAs 672 Other assets 67 Total assets 1,927,563 Liabilities Payable for investment securities purchased 460,888 TBA sales commitments (proceeds $6,601) 6,664 Payable for shares redeemed 1,441 Investment management fees payable 542 Variation margin payable on centrally cleared swaps 168 Due to affiliates 149 Variation margin payable on futures contracts 26 Payable to directors 1 Other liabilities 439 Total liabilities 470,318 NET ASSETS $ 1,457,245 Net Assets Consist of: Overdistributed net investment income $ (3,602) Accumulated undistributed net realized loss (69,528) Net unrealized gain 1,670 Paid-in capital applicable to 156,283,563 no par value shares of beneficial interest outstanding; unlimited number of shares authorized 1,528,705 NET ASSETS $ 1,457,245 26
May 31, 2017 Statement of Assets and Liabilities NET ASSET VALUE PER SHARE Investor Class ($1,456,994,603 / 156,256,681 shares outstanding) $ 9.32 I Class ($250,630 / 26,882 shares outstanding) $ 9.32 The accompanying notes are an integral part of these financial statements. 27
Statement of Operations ($000s) Investment Income (Loss) Year Ended 5/31/17 Income Interest $ 31,840 Dividend 109 Other 379 Total income 32,328 Expenses Investment management 6,630 Shareholder servicing Investor Class 1,858 Prospectus and shareholder reports Investor Class 42 Custody and accounting 251 Registration 69 Legal and audit 26 Trustees 6 Miscellaneous 18 Total expenses 8,900 Net investment income 23,428 Realized and Unrealized Gain / Loss Net realized gain (loss) Securities 6,888 Futures 2,354 Swaps 43 Net realized gain 9,285 Change in net unrealized gain / loss Securities (15,203) Futures 1,222 Swaps (259) TBA sales commitments (63) Change in net unrealized gain / loss (14,303) Net realized and unrealized gain / loss (5,018) INCREASE IN NET ASSETS FROM OPERATIONS $ 18,410 The accompanying notes are an integral part of these financial statements. 28
Statement of Changes in Net Assets ($000s) Increase (Decrease) in Net Assets Year Ended 5/31/17 5/31/16 Operations Net investment income $ 23,428 $ 28,654 Net realized gain 9,285 2,463 Change in net unrealized gain / loss (14,303) (6,236) Increase in net assets from operations 18,410 24,881 Distributions to shareholders Net investment income Investor Class (42,290) (46,337) I Class (1) Decrease in net assets from distributions (42,291) (46,337) Capital share transactions* Shares sold Investor Class 164,541 233,986 I Class 250 Distributions reinvested Investor Class 39,248 42,864 Shares redeemed Investor Class (280,235) (285,418) Decrease in net assets from capital share transactions (76,196) (8,568) Net Assets Decrease during period (100,077) (30,024) Beginning of period 1,557,322 1,587,346 End of period $ 1,457,245 $ 1,557,322 Overdistributed net investment income (3,602) (3,588) 29
Statement of Changes in Net Assets (000s) Year Ended 5/31/17 5/31/16 *Share information Shares sold Investor Class 17,492 24,656 I Class 27 Distributions reinvested Investor Class 4,176 4,517 Shares redeemed Investor Class (29,786) (30,103) Decrease in shares outstanding (8,091) (930) The accompanying notes are an integral part of these financial statements. 30
May 31, 2017 Notes to Financial Statements T. Rowe Price GNMA Fund (the fund), is registered under the Investment Company Act of 1940 (the 1940 Act) as a diversified, open-end management investment company. The fund seeks high current income consistent with high overall credit quality and moderate price fluctuation by investing at least 80% of its total assets in Government National Mortgage Association securities backed by the full faith and credit of the U.S. government. The fund has two classes of shares: the GNMA Fund (Investor Class) and the GNMA Fund I Class (I Class). I Class shares generally are available only to investors meeting a $1,000,000 minimum investment or certain other criteria. Each class has exclusive voting rights on matters related solely to that class; separate voting rights on matters that relate to both classes; and, in all other respects, the same rights and obligations as the other class. NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES Basis of Preparation The fund is an investment company and follows accounting and reporting guidance in the Financial Accounting Standards Board (FASB) Accounting Standards Codification Topic 946 (ASC 946). The accompanying financial statements were prepared in accordance with accounting principles generally accepted in the United States of America (GAAP), including, but not limited to, ASC 946. GAAP requires the use of estimates made by management. Management believes that estimates and valuations are appropriate; however, actual results may differ from those estimates, and the valuations reflected in the accompanying financial statements may differ from the value ultimately realized upon sale or maturity. Investment Transactions, Investment Income, and Distributions Income and expenses are recorded on the accrual basis. Premiums and discounts on debt securities are amortized for financial reporting purposes. Paydown gains and losses are recorded as an adjustment to interest income. Inflation adjustments to the principal amount of inflation-indexed bonds are reflected as interest income. Dividends received from mutual fund investments are reflected as dividend income; capital gain distributions are reflected as realized gain/loss. Dividend income and capital gain distributions are recorded on the ex-dividend date. Income tax-related interest and penalties, if incurred, would be recorded as income tax expense. Investment transactions are accounted for on the trade date. Realized gains and losses are reported on the identified cost basis. Income distributions are declared by each class daily and paid monthly. Distributions to shareholders are recorded on the ex-dividend date. 31
Class Accounting Shareholder servicing, prospectus, and shareholder report expenses incurred by each class are charged directly to the class to which they relate. Expenses common to both classes and investment income are allocated to the classes based upon the relative daily net assets of each class s settled shares; realized and unrealized gains and losses are allocated based upon the relative daily net assets of each class s outstanding shares. New Accounting Guidance In October 2016, the Securities and Exchange Commission (SEC) issued a new rule, Investment Company Reporting Modernization, which, among other provisions, amends Regulation S-X to require standardized, enhanced disclosures, particularly related to derivatives, in investment company financial statements. Compliance with the guidance is effective for financial statements related to periods ending on or after August 1, 2017; adoption will have no effect on the fund s net assets or results of operations. NOTE 2 - VALUATION The fund s financial instruments are valued and each class s net asset value (NAV) per share is computed at the close of the New York Stock Exchange (NYSE), normally 4 p.m. ET, each day the NYSE is open for business. However, the NAV per share may be calculated at a time other than the normal close of the NYSE if trading on the NYSE is restricted, if the NYSE closes earlier, or as may be permitted by the SEC. Fair Value The fund s financial instruments are reported at fair value, which GAAP defines as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The T. Rowe Price Valuation Committee (the Valuation Committee) is an internal committee that has been delegated certain responsibilities by the fund s Board of Trustees (the Board) to ensure that financial instruments are appropriately priced at fair value in accordance with GAAP and the 1940 Act. Subject to oversight by the Board, the Valuation Committee develops and oversees pricing-related policies and procedures and approves all fair value determinations. Specifically, the Valuation Committee establishes procedures to value securities; determines pricing techniques, sources, and persons eligible to effect fair value pricing actions; oversees the selection, services, and performance of pricing vendors; oversees valuationrelated business continuity practices; and provides guidance on internal 32