Smart Bond Investing—Types of Bonds

Mortgage-Backed Securities

 

  Bond Fact
  Unlike most bonds that pay semiannual coupons, investors in mortgage-backed securities receive monthly payments of interest and principal.
 

Mortgage-backed securities, called MBSs, are bonds secured by home and other real estate loans. They are created when a number of these loans, usually with similar characteristics, are pooled together. For instance, a bank offering home mortgages might round up $10 million worth of such mortgages. That pool is then sold to a federal government agency like Ginnie Mae or a government sponsored-enterprise (GSE) such as Fannie Mae or Freddie Mac, or to a securities firm to be used as the collateral for the new MBS.

 

The majority of MBSs are issued or guaranteed by an agency of the U.S. government such as Ginnie Mae, or by government-sponsored enterprises (GSEs), including Fannie Mae and Freddie Mac. Mortgage-backed securities carry the guarantee of the issuing organization to pay interest and principal payments on their mortgage-backed securities. While Ginnie Mae's guarantee is backed by the "full faith and credit" of the U.S. government, those issued by GSEs are not.

 

A third group of MBSs is issued by private firms. These "private label" mortgage-backed securities are issued by subsidiaries of investment banks, financial institutions, and homebuilders whose credit-worthiness and rating may be much lower than that of government agencies and GSEs.

 

The minimum investment amount is generally $1,000 (although it’s $25,000 for Ginnie Maes). Secondary trading of mortgage-backed bonds is relatively liquid in normal economic conditions and done over the counter, between dealers. Investors work with brokers, preferably those with specialized expertise in the mortgage bond arena, to buy and sell these bonds.

 

Because of the general complexity of mortgage-backed securities, and the difficulty that can accompany assessing the creditworthiness of an issuer, use caution when investing. They may not be suitable for many individual investors.

 

Varied Monthly Interest Payments

 

Unlike a traditional fixed-income bond, most MBS bondholders receive monthly—not semiannual— interest payments. There's a good reason for this. Homeowners (whose mortgages make up the underlying collateral for the MBS) pay their mortgages monthly, not twice a year. These mortgage payments are what ultimately find their way to MBS investors.

 

There's another difference between the proceeds investors get from mortgage-backed bonds and, say, a Treasury bond. The Treasury bond pays you interest only—and at the end of the bond's maturity, you get a lump-sum principal amount, say $1,000. But a mortgage-backed bond pays you interest and principal. Your cash flow from the mortgage-backed security at the beginning is mostly from interest, but gradually more and more of your proceeds come from principal. Since you are receiving payments of both interest and principal, you don't get handed a lump-sum principal payment when your MBS matures. You've been getting it in portions every month.

 

MBS payments (cash flow) may not be the same each month because the original "pass-through" structure reflects the fact that homeowners themselves don't pay the same amount each month. They often make unscheduled payments of principal, or prepayments. For this reason, MBS investors are subject to prepayment risk. The risk is highest when interest rates fall and homeowners refinance (prepay an existing mortgage). The resulting wave of prepayments means that there's a greater chance that the MBS investor will be paid all of the interest and principal ahead of schedule.

 

There are advantages to this payment structure—namely, you have your money in hand—but the climate for reinvestment has deteriorated. Interest rates have declined and you can't get the same return you had with your original bond. So, be aware that refinancing booms can be a bust for MBS investors. At the same time, issuers increasingly apply statistical models to smooth out monthly payments. Also, the pass-through structure of aggregating large numbers of loans at a single fixed rate also helps keep cash flows relatively consistent. Since the mid-1980s, issuers have also offered a type of collateralized mortgage bond called planned amortization class, or PAC bonds, designed to reduce volatility associated with prepayments.

 

Varied Monthly Payments

 

There's one more thing about those portions you've been getting—they are not the same each month. For this reason, investors who draw comfort from a dependable and consistent semiannual payment may find the unpredictability of mortgage-backed securities unsettling.

 

Types of Mortgage-Backed Securities

 

Pass-Throughs

 

The most basic mortgage securities are known as pass-throughs. They are a mechanism—in the form of a trust—through which mortgage payments are collected and distributed (or passed through) to investors. The majority of pass-throughs have stated maturities of 30 years, 15 years and five years. While most are backed by fixed-rate mortgage loans, adjustable-rate mortgage loans (ARMs) and other loan mixtures are also pooled to create the securities. Because these securities "pass through" the principal payments received, the average life is much less than the stated maturity life, and varies depending upon the paydown experience of the pool of mortgages underlying the bond.

 

Collateralized Mortgage Obligations (CMOs)

 

Collateralized mortgage obligations, CMOs for short, are a complex type of pass-through security. Instead of passing along interest and principal cash flow to an investor from a generally like-featured pool of assets (for example, 30-year fixed mortgages at 5.5 percent, which happens in traditional passthrough securities), CMOs are made up of many pools of securities. In the CMO world, these pools are referred to as tranches, or slices. There could be scores of tranches, and each one operates according to its own set of rules by which interest and principal gets distributed. If you are going to invest in CMOs—an arena generally reserved for sophisticated investors—be prepared to do a lot of homework and spend considerable time researching the type of CMO you are considering (there are dozens of different types), and the rules governing its income stream.

 

Many bond funds invest in CMOs on behalf of individual investors. To find out whether any of your funds invests in CMOs, and if so, how much, check your fund’s prospectus or SAI under the headings "Investment Objectives" or "Investment Policies."

 

To recap, both pass-throughs and CMOs differ in a number of significant ways from traditional fixed-income bonds.

 

Fixed-Coupon Bonds Mortgage Bonds
 Semiannual coupon  Monthly coupon
 Coupon amount stays the same each time  Coupon amount varies each month
 Coupon is interest only  Coupon is interest and principal
 Collect principal when bond matures  Collect principal incrementally each month
 Concise maturity date  "Average life," an estimate of when the bond will mature

 

 

Mortgage-Backed Securities Risk Report Card

  Green Checkmark Credit and default risk are real for MBSs issued by GSEs: The federal government is under no legal obligation to save a GSE from default.
  Green Checkmark Prepayment risk that acts much like call risk: You get your principal back sooner than the stated maturity, but the reinvestment opportunities are limited due to the inconsistent prepayment rates, which are driven by real estate mortgage interest rates and refinancing trends; population, geographic mobility and employment opportunities; and social and economic factors that are difficult to model.
  Green Checkmark Extension risk: The opposite of prepayment risk—the risk that interest rates will go up, lengthening the estimated maturity (but not the stated maturity) of your MBS and creating more holding-period risk.
  Green Checkmark Interest rate risk: If interest rates rise, the value of a mortgage-backed security on the secondary market will likely fall.

 

 

Mortgage-Backed Securities Snapshot

  Issuer Agencies of the federal government, GSEs and private financial organizations
  Minimum Investment Varies—generally $10,000
  Interest Payment Generally paid monthly with payments varying each month
  How to Buy/Sell Through a broker
  Bond Interest Rate Determined at origination and varies by bond
  Price Information Issue price and secondary trade data available through a broker and data vendors
  Website for More Info SIFMA: What are Mortgage Securities?

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