You may not realize it, but when you purchase a home and finance it with a mortgage, your lender doesn’t often retain ownership of your mortgage. Through a process known as securitization, your mortgage may end up as one component of the financial backing for a mortgage bond. Although the details of each mortgage bond vary, the overall features remain the same.
Creation of a Mortgage Bond
Typically, lenders sell individual mortgages to another entity on the secondary market such as Freddie Mac, Fannie Mae, Ginnie Mae or an investment bank. In turn, the purchasing entity bundles your mortgage with other mortgages into a pool of loans that securitizes a mortgage bond into a specific type of security called a mortgage-backed security, or MBS. Mortgage pools can contain, for example, 200 mortgages or 200,000 mortgages.
Mortgage Bond Backing
Most mortgage bonds are issued or guaranteed by a U.S. government agency such as Ginnie Mae (Government National Mortgage Association) or by a government-sponsored enterprise (GSE) such as Freddie Mac (Federal Home Loan Mortgage Corporation) or Fannie Mae (Federal National Mortgage Association). Mortgage bonds backed by Ginnie Mae carry the “full faith and credit” of the U.S. government as a guarantee that the bond principal and interest payments will be made on a timely basis, while GSE bonds do not have this same guarantee. However, Freddie Mac and Fannie Mae provide different guarantees, and they are authorized to borrow from the U.S. Treasury to meet their obligations.
Other mortgage bonds, commonly called “private-label” securities, may be issued by private entities, including banks, brokerage firms and homebuilders. Private-label securities carry a higher measure of risk for investors than those that are government-guaranteed or government-sponsored. Mortgage bond investors are urged to check the creditworthiness of these companies, because their credit ratings may be significantly lower than those of government agencies and GSEs.
Characteristics of Mortgage Bonds
Mortgage bonds are characterized by features such as their mortgage-backed securities, their regular payment schedule and their liquidity, to name a few features. Because of the way mortgage bonds are structured, buyers have recourse in case the bond issuer defaults – they have a claim on the amount of principal and interest payments of the mortgages in the pool.
Types of Mortgage-Backed Securities
Because of the different types of mortgages, mortgage bonds are secured by pools of loans that have similar characteristics. For example, a mortgage pool may be composed of home mortgages that have similar interest rates and maturity dates. There are two primary types of mortgage bonds – pass-through mortgage-backed securities and collateralized mortgage-backed securities. They differ in their complexity, with the former more simplistic and the latter a bit more complex.
Pass-Through Mortgage-Backed Securities
Pass-through mortgage securities are trusts that collect mortgage payments and distribute them (pass through) directly to investors. Typically, pass-through mortgage securities have maturities of five, 15 and 30 years. And although most pass-throughs include mortgage pools filled with fixed-rate mortgages, other types of mortgages, such as adjustable-rate mortgages and other types of loans, can also be sources of security pools.
Collateralized Mortgage Backed Securities
Collateralized mortgage-backed securities – also known as collateralized mortgage obligations, or CMOs – represent a more complex pass-through security. Instead of being composed of a similar mortgage pool that passes the cash flow of principal and interest to an investor, a CMO is composed of numerous pools of securities. Each of these pools, also called tranches or slices, is governed by a separate set of rules that determine how the principal and interest are distributed.
Mortgage Securitization Means Safer Investments
A common feature of mortgage bonds is that, typically, they are considered safer investments because of their securitization, where “safer” means lower risk. For example, if you’re an investor in a corporate bond and the corporation defaults on the bond, you have little recourse to collect your investment – and in some cases, you have no recourse. But if you invest in a mortgage bond, you have a claim against the value of the properties in case of default. On the downside, because of the lower risk, you may realize a lower rate of return on your investment compared to the higher yields offered on higher-risk investments.
Regular and Predictable Payments
A perk for many investors is the frequency at which mortgage bonds provide income. Instead of the annual or semi-annual payments of interest that many bonds pay, mortgage bond investors receive monthly payments that include both interest and principal.
As an example, if you purchase a Treasury bond, you’ll receive only payments of interest until the bond matures, at which time you’ll get your principal investment back. But if you purchase a mortgage bond, you’ll receive interest and principal payments until the bond matures. At the mortgage bond’s maturity, you will not receive a lump-sum principal payment because it’s been doled out to you during the life of the bond.
Liquidity Attracts Smaller Investors
The Federal Housing Finance Agency (FHFA) explains how mortgage bonds are appealing to smaller investors. These bonds are securitized; they provide regular and timely payments to investors; and bondholders can liquidate properties that represent defaulted mortgages. This liquidity factor attracts the smaller secondary mortgage market investors who would not ordinarily lean toward investing in mortgages. As a trickle-down benefit of mortgage bonds, their liquidity also helps lower the interest rates for homeowners and mortgage investors when they purchase property.
Buying Mortgage Bonds
The Financial Industry Regulatory Authority (FINRA) offers guidelines for buying mortgage bonds. Investors buy and sell these bonds through a broker, typically with a minimum investment of $10,000. The issue price and other trade data are provided by the broker, and the interest rate, which varies from bond to bond, is determined at each bond's origination. Investors generally receive monthly payments, which may vary from month to month.
Call risks, which exist for other types of bonds, mean that a bond issuer may "call" or redeem a bond before its maturity date. But in the case of a mortgage bond, investors may face a "prepayment risk." This means that the bond issuer may pay your principal sooner than the bond's stated maturity.
Historical Mortgage Bonds Backfire
A big exception to the rule that mortgage bonds are “safe” investments played out on the financial stage in the wake of the financial crisis beginning in 2007. Subprime mortgages, which were snatched up by buyers with marginal credit histories or unverifiable incomes, became the fodder for investors seeking big returns on their investment. But so many of these subprime mortgages met their demise in default that it precipitated a financial crisis so severe that many investors lost more than their shirts – to the tune of trillions of dollars.
Check a Company's Credit History
In part because of the financial crisis in the late 2000s, and in part, because all investments carry a measure of risk, FINRA urges investors to do their homework before investing in mortgage bonds – particularly when a potential mortgage bond investment is a private-label security. Investors can look to bond rating agencies for researching the creditworthiness of a particular company. The three commonly used U.S. agencies are Moody’s Investors Service, Standard and Poor’s Global Ratings and Fitch Ratings. You can find these agencies online to help inform your investing decisions.