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When it comes to finance, most people are generally familiar with different kinds of stocks and funds. Even novices have heard terms such as “value stocks,” “growth stocks,” “exchange-traded funds” and “mutual funds.” But many everyday investors have less familiarity with bonds, especially in terms of the many different options available to them.
Mortgage bonds are one such example. Understanding the intricacies of these investment vehicles can help you diversify your portfolio and generate a steady income stream.
Read on to learn what mortgage bonds are, how they work and whether or not they’re a good fit for you.
What is a mortgage bond?
Before discussing what a mortgage bond is, you should have an understanding of what a bond is. A bond is a loan from an investor to a borrower that uses the funds for operations and provides the investor with regular interest payments. It’s akin to an IOU that provides investors with yield.
A mortgage bond, simply put, is a type of bond secured by mortgages. These financial instruments typically hold real estate as collateral. Issuers sell mortgage bonds to real estate investors, who then receive regular interest payments on the underlying mortgage loans until that debt is paid off.
Mortgage bonds play an integral role in bridging bond markets, mortgage markets and real estate markets, and these assets are particularly attractive to income investors because they generate recurring interest payments. Therefore, they can be a fixture of traditional 80/20 or 70/30 portfolio allocation strategies, wherein the 20% or 30% earmarked for bonds can include mortgage-backed securities.
Importantly, mortgage bonds offer investors protection since the principal is routinely backed by a physical asset (i.e., real estate). Even in the event of a homebuyer defaulting, because the real estate is used as collateral for the bond issuer and the bondholders, those properties can be repossessed or sold off. However, because safer investments typically correlate to lower returns, mortgage bonds can produce lower yields than other types of bonds.
How do mortgage bonds work?
After a property is purchased or refinanced, the mortgage seldom remains with the original issuer. More often, it is sold on a secondary market, then packaged in a pool with other similar mortgages. From there, the entity that acquired the mortgage and pooled it can issue shares of a bond.
The following section discusses the process in detail.
Mortgage pooling and securitization
Securitization is the conversion of an asset into a marketable security. For mortgage bonds, the process entails pooling mortgages and repackaging them as interest-bearing securities. This happens when mortgage lenders sell mortgages on the secondary market to investors (e.g., investment banks), which then bundle — or pool — them before selling shares of those pooled resources to prospective bondholders looking to secure interest payments.
Mortgage tranches
Mortgage bonds are divided by risk level, amount of interest paid and maturity dates. These are referred to as tranches. For example, senior tranches can include first lien or secured loans, whereas junior tranches can include riskier second lien or unsecured loans. Because of their higher safety ratings, senior tranches are often purchased by insurance firms and pension funds while junior tranches attract hedge funds and other higher-risk investors.
Mortgage tranches allow investors to align their risk tolerance and desired investment income with a corresponding bond. Investors with long investment horizons may be comfortable with tranches offering longer maturities, while investors who want cash sooner can purchase shorter maturity investments.
Cash flows and payment structure
A mortgage bond’s tranches dictate the sequence of how and when investors get paid. Senior tranches receive interest payments first since those assets tend to have higher credit ratings than junior tranches. Those payments originate from property owners paying their mortgages. From the payments on the mortgages in a pool, the portion that is interest is used to produce yield for the bondholders.
Prepayment risk
Prepayment risk refers to the risk of a borrower repaying the principal amount of a loan earlier than expected. While prepayment of an outstanding balance benefits the borrower, it negatively impacts the yield lenders expect, or in the case of mortgage bonds, the yield the bondholders expect.
Because mortgage bonds are structured as income vehicles for investors, prepayment reduces the amount of interest generated from a mortgage pool’s payments. To mitigate this risk, debt securities can impose prepayment penalties.
Mortgage bond valuation
Mortgage bonds are valued similarly to other bonds. The valuation process involves determining the fair market value of the bond. This is most commonly done by calculating the bond’s current cash flow or its potential future interest payments. The resulting figure is known as the par value, which is the bond’s value at the date of maturity.
Why invest in mortgage bonds
If you’re wondering why and how to buy bonds, there are a few principal reasons why they make sound additions to investment portfolios.
Steady income streams
For income investors, mortgage bonds can produce reliable and easily calculable monthly payments. These bonds have fixed interest rates and can provide predictable yield for investors using a blended income strategy.
Portfolio diversification
Mortgage bonds help investors diversify their portfolios while also providing safety. Because bonds are typically more stable than equities, they’re viewed as safer investments. Stocks fluctuate in price based on numerous factors including market conditions, the economic environment, investor sentiment and news. Bond prices are more stable, and their predictability makes them a desirable conservative asset.
Secured by tangible assets
Mortgage bonds are backed by the physical real estate associated with the mortgages in the bonds’ pools. Because they are backed by real property, they’re considered lower-risk investment options. In 2023, mortgage delinquency rates fell to an all-time low, further evidencing the safety of mortgage bonds.
How to buy mortgage bonds
Mortgage-backed securities (MBSs) like mortgage bonds are bought and sold on the bond market and are available from most full-service brokerages and some discount brokerages. Some of the best stock trading apps and the best online trading platforms offer investors access to the bond market.
Mortgage bond FAQs
Do mortgage rates affect mortgage bonds?
Mortgage rates and mortgage bonds are inversely correlated, meaning that when interest rates are high, bond prices are low. When bond prices are high, interest rates are low. This is evidenced by the effect on interest rates that the Federal Reserve has when purchasing mortgage bonds. The Fed has purchased so many MBSs that it is an essential driver of the MBS market.
What are the risks of mortgage bonds?
There are two main risks with mortgage bonds and other MBSs: prepayment and loss of collateral. Prepayment risk entails a borrower — generally a homeowner — satisfying a loan's outstanding balance sooner than expected, therefore generating less interest for bondholders. Loss of collateral happens when a borrower defaults on their mortgage payments and the sale of underlying real property doesn't fully cover the loss.
What happens to mortgage bonds when interest rates fall?
Falling interest rates can be a positive thing for both homeowners and mortgage bondholders alike. For bondholders, when rates fall, the prices of mortgage bonds tend to appreciate. However, with lower rates, the average life of a mortgage bond can be shortened since borrowers can refinance to lower their payment amounts or the terms of the new mortgages. This can result in less predictable cash flow for investors.
Summary of Money's What Is a Mortgage Bond?
Mortgage bonds offer investors a low-risk option that can help them diversify their portfolios. They’re particularly attractive to income investors who are looking to generate regular and recurring yield. As debt instruments, these pools of mortgages are divided into tranches based on risk level, the amount of interest they will pay and expected maturity dates. They are then securitized and offered in shares to investors. Though they can face prepayment risk, because mortgage bonds use underlying real property as their collateral, they’re considered some of the safest investments available.
