How mortgage-backed securities and bonds work

Mortgage bonds and mortgage-backed securities are investments, like stocks and bonds. Where stocks represent ownership in a company and bonds represent ownership of debt, mortgage-backed securities represent a claim to the cash flow produced by payments on mortgage loans.

Mortgage-backed securities play a big role in the real estate market, letting mortgage issuers quickly recoup the money they’ve lent out, creating liquidity in the real estate and mortgage markets.

We’ll break down what mortgage-backed securities are, how they work, and whether investing in them is a good idea.

What are mortgage-backed securities (MBS)?

A mortgage-backed security is an investment that gives the holder rights to some of the cash flow produced by mortgage loans. Usually, an MBS includes multiple mortgages.

For example, a lender may issue ten mortgage loans and package them into a single MBS. You can then buy that MBS, and whenever the borrowers make payments on their loan, you receive those payments rather than the lender.

This means that lenders can quickly recoup the money they’ve lent out, plus earn a profit, allowing them to originate more mortgages. Investors, meanwhile, can benefit from the cash flows received from the MBS.

Types of MBS

Mortgage-backed securities can come in a few different forms, each with slightly differing features.

Pass-through

Pass-through MBSs are the simplest type of MBS. The MBS holds multiple mortgages, and investors in the MBS receive the principal and interest payments made on those loans. In effect, the payments pass-through the MBS to the investors.

A pass-through MBS generates cash flow in three ways:

• Scheduled principal: This is the amount of principal expected to be repaid by the borrowers of the loans in the MBS.
• Scheduled interest: This is the amount of interest expected to be paid by the borrowers of the loans in the MBS.
• Prepaid principal: This can include any principal already paid by the homeowner and can vary based on things like homeowner action and interest rates.

Collateralized mortgage obligation (CMO)

A CMO is a type of MBS that consists of multiple pass-through MBS packaged into a new security. The difference is that CMOs offer certain investors priority to cash flows. This allows some investors to reduce their prepayment risk, which can reduce returns if borrowers choose to pay off the mortgages ahead of schedule.

Investors can choose different classes of CMOs when investing in these MBS. The class selected can impact the price of the security and its priority when it comes to receiving payments. In general, higher-priority classes will cost more.

Types of MBS issuers

There are many different entities that can issue mortgage-backed securities, including:

• Ginnie Mae: Ginnie Mae is wholly owned by the United States government and insures loans like FHA loans and VA loans. It issues MBS in minimum amounts of $25,000 with increments of $1,000.
• Freddie Mac: Freddie Mac is a government-sponsored enterprise that is not explicitly owned or guaranteed by the U.S. government. Most of its revenue comes from helping facilitate a secondary market for residential mortgage loans, and it issues MBS in increments of $1,000.
• Fannie Mae: Like Freddie Mac, Fannie Mae is a government-sponsored enterprise that helps facilitate the secondary market for mortgages. It also issues MBS in increments of $1,000.

What is a mortgage bond?

A mortgage bond is a type of investment that is backed by real estate. Like other mortgage-backed securities, they are backed by a loan or pool of mortgage loans.

Lenders originate mortgage loans to borrowers who wish to buy real estate. They then package those loans into mortgage bonds and sell the bonds to investors. The investors then receive the principal and interest payments made by the borrowers.

Typically, loans are pooled together based on factors like risk and maturity. Loans to borrowers with similar risk profiles will often be packaged together, so high-risk loans get packaged with high-risk loans and low-risk loans with other low-risk loans.

If a borrower defaults on their loan, the bondholder can foreclose on the property and sell it, helping recoup some of the lost income.

Mortgage bonds differ from corporate bonds or government bonds because they can represent multiple different loans, and their payments can be less predictable.

Mortgage bonds vs. fixed-coupon bonds

A fixed-coupon bond is a bond that has a known payment to investors. Most corporate and government bonds are fixed-coupon bonds. They have a face value and an interest rate, and you can calculate exactly how much you’ll receive based on those two numbers.

For example, a $1,000 bond with a 5% interest rate will pay $50 each year until it matures. At maturity, the full amount of principal is repaid.

With mortgage-backed securities, the payments can be less predictable. For example, if some of the mortgages backing the MBS have variable interest rates, the amount paid in interest can change over time. Some borrowers may also opt to pay their loans off ahead of schedule, reducing the amount of interest paid. Additionally, the principal is repaid each month along with interest.

How do MBS and mortgage bonds work together?

Mortgage bonds and mortgage-backed securities work together because mortgage bonds are a form of MBS. MBS can come in many forms and with many different payment structures, but mortgage bonds are among the simplest, working much like other forms of bonds.

Investors who wish to get exposure to real estate and to produce a stream of income can purchase mortgage bonds or other forms of MBS.

Pros and cons of investing in mortgage bonds

Investing in mortgage bonds can be complicated, so it’s important to consider the pros and cons before investing.

Pros

Some reasons to invest in mortgage bonds include:

• Income: Mortgage bonds offer a stream of income to investors in the form of monthly principal and interest payments.
• Diversification: Mortgage bonds allow you to diversify your investment portfolio by adding exposure to real estate to your investment.
• Secured by real estate: Unlike other bond investments, mortgage bonds are secured by physical assets in the form of real estate.

Cons

Before investing in mortgage bonds, keep these drawbacks in mind.

• Cash flow can be inconsistent: Your monthly cash flow can change if borrowers miss payments or mortgage rates change.
• Prepayment risk: You could see a lower return than expected if borrowers opt to pay their loans off ahead of schedule.
• Low yields. Mortgage bonds, because they are secured by real estate, may have lower yields than some other investments, like corporate bonds.

Questions investors should ask before getting mortgage bonds

Before investing in a mortgage bond or other MBS, consider these questions:

• What is the collateral that is being held by the MBS? Are the assets commercial or residential real estate, and how does that affect risk? Do you expect real estate in the area where the properties are to appreciate or lose value?
• What is the pool’s underlying mortgage type? Are rates fixed or variable? If variable, could rates rise or fall in the future, affecting your returns?
• Who is issuing the mortgage bond? Is the issuer a trustworthy entity that rates loans properly?
• Will this diversify my existing portfolio? If you already have exposure to real estate, such as by owning a home, do you need to add diversification to your portfolio?
• How has the real estate market been performing? If real estate is doing poorly or on a downtrend, MBS could be higher-risk investments. On the other hand, they can be better investments in a strong real estate market.

FAQs

These are some of the most common questions people have about mortgage bonds and MBSs.

How do people make money on mortgage bonds?

Investors make money on mortgage bonds the same way they do with other bonds. Investors can hold the bonds to maturity, receiving their principal back plus interest, or sell the bond to other investors at a higher price than they paid.

Do banks sell mortgage bonds?

Yes, banks may sell mortgage bonds. Many lenders will package multiple mortgages into an MBS and sell them to investors.

Are mortgage bonds a good investment?

Mortgage bonds can be a good investment, but like all investments, they are subject to risk. They may be a good fit for people looking to produce cash flow from their investments or diversify their portfolio into real estate.

What is the biggest risk of mortgage bonds?

Mortgage bonds have a few different risks, including the risk that borrowers will default and property values will fall, making it hard to recoup the principal lent to the borrower. Prepayment risk can also result in lower-than-expected returns.

Can you lose money on mortgage bonds?

Yes. Like any investment, mortgage bonds are subject to risk, and it is possible to lose money by investing in them.

The bottom line: Mortgage bonds can diversify your real estate portfolio

Mortgage bonds are a type of mortgage-backed security that lets you receive cash flow by investing in a pool of mortgage loans. There are many different forms of MBS, so it’s important to do your research to make sure you understand what you’re investing in and any potential risks.

If you’re considering investing in a mortgage bond, consider checking today’s mortgage rates to get a sense for what return you can expect from your investment. And if you’re considering buying a home, you can reach out to Rocket Mortgage for more loan information.