When it comes to investing, it seems like there are endless options available today. Among the most popular investment options are real estate, stocks and bonds. And to keep things interesting, within each of these investment categories, you’ll find a variety of investment options to consider.
We’re going to focus on one investment category: bonds. Bonds are issued by governments and corporations to raise money. In return for your investment, the issuer pays out interest over a set time frame followed by repayment of the bond at maturity.
The bond type we’re going to focus on is the mortgage bond.
A mortgage bond is backed by a pool of mortgages that serve as collateral for the bond. The idea is that the bond will be repaid as long as most homeowners in the pool regularly pay their mortgage.
In this article, you’ll learn more about mortgage bond investing options, the risks and benefits of investing in mortgage bonds, and how to get started.
How Do Mortgage Bonds Work?
Before we dive into mortgage bonds, let’s take a peek behind the curtains to see how mortgage lenders usually operate. It may surprise you, but mortgage lenders typically don’t service the loans they issue for very long.
It’s common practice for mortgage lenders to sell the loans they’ve issued soon after they’re funded. Lenders that operate like this primarily profit from the money they make originating loans and selling them to investors, not from the interest paid on loans by borrowers.
Lenders commonly sell bundled mortgages on the secondary market to investment banks or government-sponsored enterprises, like Fannie Mae or Freddie Mac. The investment bank or entity that purchases the lender’s loans will likely combine them with a pool of other mortgage loans and sell them to investors as mortgage-backed bonds.
FYI: A mortgage bond is different from a mortgage loan. A mortgage loan is a debt a borrower agrees to repay a lender with interest over the length of the loan. A mortgage bond is an investment (like a stock or bond) that is backed by a pool of mortgage loans. The mortgages act as collateral for the bond.
A valuable asset pledged as security for a loan that can be seized in the event of default.
Investors make money on a mortgage bond in two ways:
- Regular interest payments: When homeowners make their monthly mortgage payments, the bond issuer pays out a portion of the interest to bondholders.
- Appreciation: Because mortgage bonds are investment securities, their value can go up or down. If you sell your bond when the value has appreciated, you’ll make a profit.
Mortgage bonds also feature built-in protections for investors. If a significant portion of mortgages default, the bond issuer can sell the properties backing the bond. This creates a low-risk investment environment for investors.
Bonds are passive, low-risk investments and typically have a lower rate of return than riskier investment options.
A GSE is sponsored and regulated by the U. S. government but operates as a private company. There are two GSEs: Fannie Mae and Freddie Mac. And they each play an essential role in the secondary market for mortgage-backed securities.
Fannie Mae and Freddie Mac also play a major role in real estate. Both set the underwriting standards for conventional loans. In fact, Fannie and Freddie will only purchase mortgages that meet their underwriting standards.
Fannie Mae and Freddie Mac purchase a large share of the mortgages lenders sell on the secondary market. When Fannie and Freddie purchase mortgages, they create more liquidity for lenders. And because they no longer have mortgage debt on their books, lenders can continue issuing home loans, which helps keep mortgage rates low.
Because loans must meet Fannie and Freddie’s standards, it’s less attractive for lenders to sell high-risk mortgage loans as mortgage bonds. Incentivizing lenders to meet these standards helps keep the mortgage bond market stable, and it makes GSE-backed mortgage bonds good low-risk investments.
What Are the Different Types of Mortgage Bonds?
There are two types of mortgage bonds: pass-through securities and collateralized mortgage-backed securities.
Pass-through securities
The most common type of mortgage bond (and the easier of the two to understand) is the pass-through security. Pass-through securities get their name from the monthly payments that pass from borrowers to third-party servicers for the bond issuers through to bondholders.
Let’s say you buy a mortgage-backed bond, and your bond is a pass-through security backed by 100 mortgage loans. After homeowners pay the loan servicer, the servicer will pass through the amount your bond entitles you to, which is 1/100 of the monthly mortgage payments on the 100 loans.
Collateralized mortgage-backed securities (CMOs)
A bit less common – and a bit more complex – CMOs are a type of mortgage-backed, pass-through security, but with a key difference: the mortgages are split into tranches with the level of risk in a tranche will be reflected by its rating and interest rate.
Let’s say you buy a CMO backed by 100 mortgage loans. The collected profits from monthly payments on the mortgages would then be split between the tranches, each with its specific interest rate.
The most senior tranche, which is the least risky tranche, may offer lower earnings because it is first in line to receive payments and is made up of highly rated loans that are not likely to default. The junior tranche, which is the riskier tranche, might offer higher earnings to compensate investors for their additional risk.
As an investor, you can purchase different tranches based on your desired level of risk and return.
The right mortgage bond for you will depend on your investment goals and objectives. Less experienced investors may prefer the simplicity of pass-through securities, while those looking for more options may appreciate CMOs.
Do Mortgage Bonds Affect Mortgage Rates?
While many factors affect mortgage rates, like decisions made by the Federal Reserve, the health of the economy and inflation, the bond market is another factor that can affect mortgage rates.
The bond market affects mortgage rates, but the relationship is inverse. When mortgage rates are low, mortgage bond prices tend to rise. When mortgage rates are high, mortgage bond prices tend to fall.
Why? When mortgage interest rates are low, prospective home buyers flood the market to purchase homes at affordable mortgage rates. More home buyers mean more mortgages for lenders to sell on the secondary market.
When mortgage interest rates go up, homes are more expensive to buy. Fewer mortgages mean fewer mortgage bonds, which drops their value.
We’ve seen this in recent news. Mortgage rates were at historic lows, and home buying was at record highs during the COVID-19 pandemic. During this period, the demand for mortgage bonds spiked. Now that mortgage rates are beginning to climb and home buying is starting to slow down, mortgage bond rates are likely to decrease.[1]
Should You Invest in Mortgage Bonds?
Investors should routinely balance the risk they face against the reward they stand to receive. Mortgage bonds are safe and reliable. Remember, many mortgage bonds are backed by the full faith and credit of the federal government. It doesn’t get much safer and more reliable than that.
Stocks and other investments may promise more aggressive returns, but they also come with a higher level of risk. Stock investors know their investments can lose value quickly and without warning.
Mortgage bonds are much more stable. They offer investors a predictable revenue stream, and the principal investment is almost always returned.
Risks of Investing in Mortgage Bonds
While mortgage bonds are considered safe investments, there are still some risks to be aware of. The two most common risks are inflation and the risk of default.
- Inflation: Mortgage bond rates are trending around 1% – 3%. But when you’re only seeing a modest return on a short-term investment, inflation can eat away at your expected profits. That’s why it helps to invest in mortgage bonds long term. A long-term investment allows you to ride out market fluctuations. For example, if you’re close to retiring, purchasing mortgage bonds while inflation is high may not be the best profit-generating use of your investment dollars.
- Risk of default: Although Fannie Mae and Freddie Mac back many mortgage bonds – they don’t back all of them because they only buy conventional mortgages. Some private companies issue mortgage bonds that are backed by nontraditional mortgages. These mortgage-backed securities may provide a better return, but they are more susceptible to defaults. You only need to look as far back as the 2008 financial crisis to recognize the level of risk you might be taking with nonconventional loans. Investors collectively lost millions as borrowers began to default on the subprime loans that were bundled into mortgage bonds.
To Bond or Not To Bond
So, should you invest in mortgage bonds? Well, that’s for you to decide. Historically, many investors have found mortgage bonds to be a reliable, low-risk way to invest their money.
While no investment is without risk, mortgage bonds typically offer a predictable stream of income, which can be a valuable addition to any investment portfolio.