A mortgage bond or mortgage-backed security is a bond that relies on a pool of mortgages for collateral. Government agencies or private companies buy up mortgages, then issue the bonds. The bonds give buyers a claim on the principal and interest payments made by the mortgagees in the pool. The process is sometimes called the "securitization of mortgages."
One feature of mortgage bonds is that the payments are regular and fairly predictable. In a pass-through arrangement, the bond issuer passes along a share of the interest and principal received each month: If you buy 7 percent of the pool, you get a 7 percent cut. Property owners who prepay their mortgage can throw off the payment schedule but CMOs -- collateralized mortgage obligations -- don't have that problem. CMOs set a regular schedule for paying out the principal over the life of the bond.
If an agency such as the Government National Mortgage Association -- "Ginnie Mae" -- puts together the pool, the mortgage bonds are considered very low risk. Ginnie Mae, for example, guarantees the investors will receive timely payments and the federal government backs the guarantee. Mortgage bonds also offer a better rate of return than most government-backed investments. Inevitably, some property owners will default on their mortgages, but by bundling them into pools, the risk is lower than if a bond were backed by one mortgage.
Some mortgage bonds offer higher returns because the issuer has bundled together a lot of high-risk mortgages to create the pool. Other issuers are themselves risky businesses: check out the credit history of any company whose mortgage pool you plan to buy into. Mortgage borrowers refinancing and paying off the mortgage early can throw off your investment strategy. Buyers typically refinance when rates drop, so you get a big payoff when your other investment options aren't very profitable.
Mortgage-backed securities are liquid, because there are lots of dealers and investors in the market looking to buy. If you need to convert your mortgage bonds to cash, it shouldn't be too difficult, provided you invested in a reasonably safe mortgage pool. CMOs are less liquid because the precise payout schedule the bonds set up makes different CMOs quite distinctive. The price of a CMO when you sell it may vary from your purchase price more than, say, a pass-through bond would.
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