What are mortgage bonds and how do they work?

It may surprise you to learn that the home buying process isn’t over after you close on a mortgage. There might be 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.

Mortgage bond definition

A mortgage bond is an investment backed by a pool of mortgages that a lender trades to another party. A mortgage bond is different from a mortgage loan, which is an agreement between a lender and a borrower that allows a borrower to own a property they could not purchase outright.

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.

How do mortgage bonds work?

After a lender issues a mortgage loan to a borrower, the lender bundles mortgages together before selling the bundles 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.

Mortgage bonds are considered low-risk investments. Usually, they have a lower return rate than riskier investment options. 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 remain a major part of the US economy

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.

Mortgage bonds and fixed-coupon bonds

Mortgage bonds differ from standard fixed-coupon (also known as fixed-income) bonds in several ways. An example of a fixed-coupon bond would be a corporate bond, which is issued by a company to raise funds and then pays out a fixed amount in interest until it matures. Our chart compares key differences between the two types of bonds.

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^®.