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What Are Mortgage Bonds And How Do They Work?

December 21, 2023 4-minute read

Author: Victoria Araj

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It may surprise you to learn that the home buying process isn’t over after you close on a mortgage. There’s nothing left for you to do, but in all likelihood, your lender will immediately sell your mortgage and add it to a pool of other mortgages.

This is what’s known as a mortgage bond, and it’s a type of mortgage-backed security (MBS). Mortgage bonds protect lenders and make it possible to invest in real estate at an affordable price point. This article will explain what a mortgage bond is and how it affects the real estate market.

Mortgage Bond Definition

Lenders sell a mortgage bond to real estate investors, who receive periodic interest payments on mortgage loans until they’re paid off. An investor has a claim on the assets put up as collateral, which would be the houses, and can repossess them in the event of mortgage 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 home and use proceeds from a foreclosure sale to ensure investors get paid.

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How Do Mortgage Bonds Work?

Before diving into the different types of mortgage bonds and their benefits, it’s important to understand how they work.

Infographic showing example of CMO.

After a lender issues a mortgage loan to a borrower, the lender combines the mortgage with other mortgages and sells the bundle of mortgages to federal government agencies, government-sponsored enterprises (GSEs) or investment banks. The GSE or bank purchases the bundle and groups them with more mortgage loans into a “mortgage pool.” Then they sell them to investors as mortgage bonds.

Investors can earn a profit on mortgage bonds in two ways:

  • Appreciation: As with any investment security, a mortgage bond’s value can fluctuate. You’ll earn additional revenue if you sell your mortgage bond once its value has appreciated.

  • Regular interest payments: When a borrower makes monthly mortgage payments, the issuer pays out a chunk of the interest to shareholders.

Mortgage bonds are low-risk investments. They usually have a lower return rate than riskier investment options.

What Is The Relationship Between Bonds And Mortgage Rates?

Mortgages and the bond market have an inverse relationship with each other. If bonds are expensive, that means mortgage rates will be low. When bonds are inexpensive, mortgage rates will be high.

Government-Sponsored Enterprises

A government-sponsored enterprise is a government-regulated financial services corporation created to improve credit flow in certain parts of the economy. GSEs don’t lend money directly. They make borrowing easier for individuals.

Fannie Mae and Freddie Mac are probably the best-known examples of a GSE. The organizations help the real estate market operate with more efficiency and transparency.

In particular, they ensure that MBS investors can safely invest in real estate. Mortgage-backed securities are a more secure, low-risk investment because they’re backed by GSEs or the federal government.

Advantages And Disadvantages Of Mortgage Bonds

Like any investment, it’s important to be aware of both the advantages and disadvantages. Familiarize yourself with a few pros and cons before investing in mortgage bonds.

Advantages:

  • Protection for shareholders: If a homeowner defaults on payments, shareholders have a guarantee for payment and interest from the bond issuer.

  • Available to shareholders with poor credit: Poor credit isn’t a problem. Investors with poor credit can access larger amounts of capital at lower borrowing costs.

  • Safe investment choice: Mortgage bonds are a safer investment than stocks.

Disadvantages:

  • Risk of loss: There’s a risk of losing money on an MBS if interest rates are lower than long-term inflation.

  • Yields are lower: Yields are lower than corporate bond yields.

Why Invest In The Mortgage Bond Market?

Investors typically purchase mortgage bonds because they’re looking for a reliable and safe income stream. Most investors favor mortgage-backed securities over Treasury bonds. They believe an MBS is a safer investment because they are backed by real property and the U.S. government. And there is an option to sell foreclosed properties to recover their losses. This makes them a good option for conservative investors.

A mortgage bond can also be a good source of reliable income. When a homeowner takes out a mortgage, they repay the loan’s principal balance and make interest payments. Recurring interest payments can become a stable source of income for investors.

Mortgage Bonds And Fixed-Coupon Bonds

Mortgage bonds, like pass-through securities, differ from standard fixed-income bonds, like corporate bonds, in several ways. Our chart compares key differences between the two.

Mortgage Bonds

Fixed-Coupon Bonds

Monthly coupon

Semiannual coupon

Coupon made up of interest and principal

Coupon made up of interest

Coupon amount fluctuates

Coupon amount remains the same

Accrue principal gradually every month

Accrue principal when bond matures

Average life

Short maturity date

Mortgage Bonds FAQs

Here are some commonly asked questions about mortgage bonds and how they function.

Do mortgage bonds still exist?

Yes, mortgage bonds are purchased and sold extensively in financial markets. Mortgage bonds provide a stable income stream and can be a great addition to an investment portfolio.

What’s the difference between a mortgage bond and a mortgage loan?

Infographic describing the difference between mortgage bonds and loans.

A mortgage bond is an investment backed by a pool of mortgages that a lender trades to another party.

A mortgage loan is a secured agreement between a lender and a borrower on a property. The borrower must repay the money they borrowed plus interest over a set period of time.

What are the risks of mortgage bonds?

Some main disadvantages of mortgage bonds are the risk of losing collateral and receiving lower yields than corporate bonds.

Are mortgage bonds a safe investment?

Investors generally consider mortgage bonds a safer investment because of the security that comes with real property. And investors can sell a foreclosed property to recoup their losses.

Is a traditional investment strategy a better option for you?

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The Bottom Line

Once you close on your mortgage, it may be bought and sold several times over the life of the loan. Mortgage bonds are a safe and reliable investment for conservative investors and free up cash so lenders can continue to offer mortgages to home buyers.

If you’re interested in buying a home, learn as much as you can about how the home-buying process works. If you’re ready to purchase a home, apply for a mortgage today with Rocket Mortgage®.

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Victoria Araj

Victoria Araj is a Section Editor for Rocket Mortgage and held roles in mortgage banking, public relations and more in her 15+ years with the company. She holds a bachelor’s degree in journalism with an emphasis in political science from Michigan State University, and a master’s degree in public administration from the University of Michigan.