Buy Mortgage Bonds
In a pass-through MBS, the issuer collects monthly payments from a pool of mortgages and then passes on a proportionate share of the collected principal and interest to bondholders. A pass-through MBS generate cash flow through three sources:
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CMOs take the cash flow from pass-throughs and segregate it into different bond classes known as tranches, which provide a time frame, or window, during which repayment is expected. This gives investors some level of payment predictability. The tranches prioritize the distribution of principal payments among various classes and serve as a series of maturities over the life of the mortgage pool.
Mortgage-backed securities typically offer yields that are higher than government bonds. Securities with higher coupons offer the potential for greater returns but carry increased credit and prepayment risk, meaning the realized yield could be lower than initially expected. Investors may receive higher payments compared to the income generated by investment-grade corporate issues. A portion of these payments may represent return of principal due to prepayments.
Credit risk is affected by the number of homeowners or borrowers in the pool of mortgages who default on their loans. Credit risk is considered minimal for mortgages backed by federal agencies or government-sponsored enterprises.
While MBS backed by GNMA carry negligible risk of default, there is some default risk for MBS issued by FHLMC and FNMA and an even higher risk of default for securities not backed by any of these agencies, although pooling mortgages helps mitigate some of that risk. Investors considering mortgage-backed securities, particularly those not backed by one of these entities, should carefully examine the characteristics of the underlying mortgage pool (e.g., terms of the mortgages, underwriting standards, etc.). Credit risk of the issuer itself may also be a factor, depending on the legal structure and entity that retains ownership of the underlying mortgages.
In general, bond prices in the secondary market rise when interest rates fall and vice versa. However, because of prepayment and extension risk, the secondary market price of a mortgage-backed security, particularly a CMO, will sometimes rise less than a typical bond when interest rates decline, but may drop more when interest rates rise. Thus, there may be greater interest rate risk with these securities than with other bonds.
This is the risk that homeowners will make higher-than-required monthly mortgage payments or pay their mortgages off altogether by refinancing, a risk that increases when interest rates are falling. As these prepayments occur, the amount of principal retained in the bond declines faster than originally projected, shortening the average life of the bond by returning principal prematurely to the bondholder. Because this usually happens when interest rates are falling, the reinvestment opportunities can be less attractive. Prepayment risk can be reduced when the investment pools a large number of mortgages, since each mortgage prepayment would have a reduced effect on the total pool.
In the case of CMOs, when prepayments occur more frequently than expected, the average life of a security is shorter than originally estimated. While some CMO tranches are specifically designed to minimize the effects of variable prepayment rates, the average life is always, at best, an estimate contingent on how closely the actual prepayment speeds of the underlying mortgage loans match the assumption.
This is the risk that homeowners will decide not to make prepayments on their mortgages to the extent initially expected. This usually occurs when interest rates are rising, which gives homeowners little incentive to refinance their fixed-rate mortgages. This may result in a security that locks up assets for longer than anticipated and delivers a lower-than-expected coupon, because the amount of principal repayment is reduced. Thus, in a period of rising market interest rates, the price declines of MBSs would be accentuated due to the declining coupon.
Depending on the issue, the secondary market for MBSs are generally liquid, with active trading by dealers and investors. Characteristics and risks of a particular security, such as the presence or lack of GSE backing, may affect its liquidity relative to other mortgage-backed securities.
CMOs can be less liquid than other mortgage-backed securities due to the unique characteristics of each tranche. Before purchasing a CMO, investors should possess a high level of expertise to understand the implications of tranche-specification. In addition, investors may receive more or less than the original investment upon selling a CMO.
Lenders sell a mortgage bond to real estate investors, who receive interest payments on mortgage loans until they are paid off. An investor has a claim on the assets put up as collateral, such as a house, and can repossess them in the event of a default.
Since a group of assets secures mortgage-backed bonds, this offers some protection to the bondholder. If a borrower defaults on their mortgage, the bondholder can sell the collateral to ensure the principal gets paid.
If you take out a mortgage through a bank, the bank will not typically retain ownership of that mortgage. Instead, the bank will securitize a group of mortgages into a financial product called a mortgage-backed security (MBS).
There are a few ways mortgage bonds, such as pass-through securities, differ from standard fixed-income bonds, like corporate bonds. The chart above compares a few of the main differences between the two.
Once you close on your mortgage, it may be bought and sold multiple times over the life of the loan. Mortgage bonds are a safe and reliable investment for conservative investors and allow lenders to make mortgages more widely accessible to consumers.
A mortgage-backed security (MBS) is an investment secured by a collection of mortgages bought by the banks that issued them. Mortgage-backed securities are bought and sold on the secondary market. An MBS is a type of asset-backed security. Asset-backed securities have made mortgage financing and home loan processes easier.
Most mortgage-backed securities are issued by Fannie Mae, Freddie Mac and Ginnie Mae. These are government-sponsored enterprises that buy mortgage loans. These companies were designed to make homeownership more accessible to consumers.
With MBSs, the bank acts as the middleman between the homeowners and investors. Individual mortgages are closed by banks and sold as conventional loans. From there, they are added to a pool of similar mortgages and packaged as a mortgage-backed security. The banks then sell those mortgages on the bond market.
To create an MBS, the bank will bundle your loan with hundreds or thousands of other mortgages. These loans are then sold to an investment bank as a single bond. The investment bank then sections off the loans by their quality and sells them to other investors. Loan characteristics and risk profile determine inclusion in a mortgage-backed security.
Collateralized mortgage obligations (CMOs) are more complex than mortgage pass-throughs. In a CMO, the mortgages are organized into separate tranches based on rates, risk, and maturity dates. The different tranches are given credit ratings, which determine the mortgage-backed securities rates.
The Federal Reserve had only an indirect impact on mortgage rates until 2008. Around this time, the Fed began buying MBSs directly in order to support the economy, help decrease mortgage interest rates and add liquidity to the market. This practice continued for over a decade, with the Fed amassing more than $2 trillion in MBS holdings. Recently, however, the Fed has made the decision to slowly exit the MBS market by halting its continual purchasing of bonds.
Generally, a bond that matures in one to three years is referred to as a short-term bond. Medium- or intermediate-term bonds are generally those that mature in four to 10 years, and long-term bonds are those with maturities greater than 10 years. Not all bonds reach maturity. Callable bonds, which allow the issuer to retire a bond before it matures, are common.
Savings bonds are also issued by the federal government and backed by the "full faith and credit" guarantee. Unlike many other types of bonds, only the person(s) in whose name a savings bond is registered can receive payment for it.
The two most common types of savings bonds are Series I and Series EE bonds. Both are accrual securities, meaning the interest you earn accrues monthly at a variable rate and is compounded semiannually. Interest income is paid out at redemption.
Most corporate bonds trade in the over-the-counter (OTC) market. TRACE, the Trade Reporting and Compliance Engine, provides real-time price information for corporate bonds. TRACE brings transparency to the fixed income market and helps create a level playing field for all market participants by providing comprehensive, real-time access to bond price information.
Agency securities are bonds issued by U.S. federal government agencies (other than the U.S. Treasury) or by GSEs. Most agency bonds pay a semiannual fixed coupon and are sold in a variety of increments, generally requiring a minimum initial investment of $10,000.
With the exception of bonds issued by Ginnie Mae, agency securities are not fully guaranteed by the U.S. government. The issuing agency will affect the strength of any guarantee provided on the agency bond. Evaluating an agency's credit rating before you invest should be standard procedure. Many credit rating agencies make this information available on their website.
Municipal bonds, or muni bonds, are issued by states, cities, counties, towns villages, interstate authorities, intrastate authorities and U.S. territories, possessions and commonwealths to support their obligations and those of their agencies. They are generally backed by taxes or revenues received by the issuer.
No two municipal bonds are created equal, which can make the muni bond illiquid. The Municipal Securities Rulemaking Board (MSRB) has educational information on muni bond investing, and its EMMA website has tools, data and disclosure documents to help compare and evaluate municipal securities. 041b061a72