A mortgage bond is a bond that is secured by a mortgage or a pool of mortgages, typically backed by real estate holdings and other real property. The income stream of a mortgage bond comes directly from the mortgage payments made by homeowners.
Key Takeaways
- Secure Investment: A mortgage bond is backed by real estate holdings or real property.
- Default Management: In default situations, mortgage bondholders can sell off the underlying property to compensate for the default.
- Lower Return, Higher Safety: Mortgage bonds tend to be safer than corporate bonds and hence, usually offer a lower rate of return.
Understanding Mortgage Bonds
Mortgage bonds offer security for investors since the principal is safeguarded by valuable assets. In the event of default, mortgage bondholders can liquidate the underlying property to secure payment.
However, this safety comes with a trade-off: mortgage bonds generally yield a lower rate of return as compared to traditional corporate bonds, which are supported only by the issuing corporation’s promise and ability to pay.
When you finance a home purchase with a mortgage, the lender often sells the mortgage on the secondary market to another entity, such as an investment bank or a government-sponsored enterprise (GSE). These entities bundle the mortgage with others, issuing bonds backed by numerous mortgages.
Homeowners’ mortgage payments subsequently cover the yield on these mortgage bonds. Assuming most homeowners in the pool continue to make payments, mortgage bonds are considered reliable and safe income-producing securities.
Advantages and Disadvantages of Mortgage Bonds
Advantages
- Security: In case of homeowner default, mortgage bondholders have a claim on the property’s value. Investors in stocks or corporate bonds may lack such recourse.
- Lower Risk: Mortgage bonds are generally safer investments compared to stocks or unsecured corporate bonds.
- Liquidation Backup: If necessary, the property securing the bond can be sold to offset losses from defaults.
Disadvantages
- Lower Yields: Due to the securitization of mortgages, such bonds often yield lower returns compared to corporate bonds.
- Dependency on Property Market: The bond’s value is directly tied to the health of the real estate market.
Noteworthy Fact
The Federal Reserve held approximately $2.4 trillion in mortgage-backed securities as of March 20, 2024.
Subprime Mortgage Bonds: A Cautionary Tale
The late 2000s financial crisis showcased a significant exception to the general safety of mortgage bonds. Investors had purchased bonds backed by subprime mortgages—loans offered to buyers with poor credit or unverifiable income—seeking higher yields but still expecting security from collateralized debt.
However, as numerous subprime mortgages defaulted, the crisis unfolded, leading to millions in losses and greater scrutiny of such securities. Despite this, the Fed continues to hold a large amount of mortgage-backed securities.
Persistence of Mortgage Bonds
Mortgage bonds remain integral to financial markets despite their tarnished reputation post-2008 crisis. They offer liquidity, free up bank balance sheets, support the housing market, and present a viable investment opportunity in home real estate.
Why Invest in Mortgage Bonds?
Investors are attracted to mortgage bonds because they often yield higher returns compared to government bonds. Depending on the credit rating, they may also offer better returns than investment-grade corporate bonds.
Banks and Mortgage Bonds: Profit Mechanism
Banks profit from mortgage bonds by selling originated mortgages to mortgage aggregators or investors, who then bundle the loans into mortgage-backed securities. Liquidating mortgages allows banks to issue new loans, thus continuing the cycle.
The Bottom Line
Mortgage bonds present a relatively safer investment option than corporate bonds as they are collateral-backed, although they may not offer high returns. Investors should assess the quality of underlying assets to evaluate the risk of default. Careful consideration of these factors ensures a balanced, informed investment strategy.
Related Terms: MBS, collateral, securitization, home loans, interest rate.
References
- Federal Reserve Bank of St. Louis. “Assets: Securities Held Outright: Mortgage-Backed Securities: Wednesday Level”.
