Everything You Need to Know About Mortgage-Backed Securities

In today’s market, there are a plethora of investments vying for your money’s attention.  The clearest path to choosing the right investment means understanding each of your options.  Traditionally, mortgage-backed securities have been major breadwinners in many investors’ portfolios, but as with any investment, these securities come with their own set of risks and rewards.

What Is A Mortgage-Backed Security?

A mortgage-backed security also referred to as an MBS, is an investment that begins its life as a home loan.  Mortgage-backed securities are a type of bond that represents an investment in a block of real estate loans.  Introduced in 1968, this security was designed to help banks free up funds being monopolized in the form of mortgages.

How It Works

Traditionally, when a borrower applies for a mortgage, the bank lends the borrower that money, and the borrower pays the loan back plus interest.  As it is with most home loans, banks are responsible for backing these loans for the lifetime of the mortgage, most of which are typically set at 30 years.

When mortgage-backed securities were introduced, banks received the option of selling a pool of real estate loans and their interests streams to investors.  Once purchased, these loans were removed from the original bank’s ledger, and freed up funds, allowing banks to offer more loans to more borrowers.  Now in the hands of an investment bank, these institutions were able to partition sets of hundreds or even thousands of loans by quality and sell these loans to even more investors.  In short, even though a borrower pays a bank for their mortgage, they’re likely paying investors to whom the loans were sold, helping the bank free up capital for other investments.

Types of Mortgage Bonds

While all the same in essence, when it comes to mortgage-backed securities, there are a couple of different types of bonds that investors may choose from.  The two most common bonds of this type are PTPCs and CMOs.

Pass-Through Participation Certificates

A pass-through participation certificate is often thought of as the simplest form of an MBS.  They’re a type of fixed-income security wherein the investor is paid on a regular basis from both the principal balance and the interest on the mortgage.  These certificates don’t mean that the holder owns these said securities, only that they’re entitled to any income produced by the security.

Collateralized Mortgage Obligation

Comprising mortgages organized by risk level and maturity, a collateralized mortgage obligation, or CMO, is a bond that receives its cash flow from borrowers paying their mortgages.  It’s important to note that CMOs are similar to another type of bond called collateralized debt obligations (CDOs), but instead of including various types of loans, only include mortgages.  CMOs are categorized into tranches (slices or portions), that are sold to investors based on the quality of the original loan.  Some may come with higher risk or higher interest rates.  A financial professional can help you determine if this is the right investment type for you.

Who Issues Mortgage-Backed Securities?

The majority of MBSs are backed by Ginnie Mae (the Government National Mortgage Association, a U.S. government agency), Fannie Mae (the Federal National Mortgage Association), or Freddie Mac (the Federal Home Loan Mortgage Corporation).

Ginnie Mae is backed by the full faith and credit of the United States government and ensures that investors receive regular and timely payments.  Its sister organizations, Freddie Mac and Fannie Mae are also able to provide some guarantees, though are not backed by the government.  These institutions have the authority to borrow funds from the U.S. treasury to ensure payments to their investors.

What Are the Benefits Of Mortgage-Backed Securities?

The biggest benefit of mortgage-backed securities for investors is that they provide a passive, monthly income stream.  While this income may vary from month to month based on the interest rate, they’re also a great way to diversify an investor’s portfolio on a geographic level, considering that these loans can come from all corners of the country.  Classically, mortgage-backed securities yield higher returns than other types of investments.  Furthermore, these bonds typically have high credit quality in comparison to other securities.

What Are The Risks Of Mortgage-Backed Securities?

As with any investment, mortgage-backed securities aren’t without risk.  These bonds are subject to risk when mortgage rates begin to rise or fall.  When rates begin to fall, these securities begin to pay back more quickly, which means they have shorter lives and have fewer returns.

Alternatively, if mortgage rates begin to climb, they pay out more slowly, also shortening the life of the loan, meaning a smaller return on investment over a longer period of time.

MBSs arReady To Invest In Mortgage-Backed Securities?e also subject to risks like:

  • Interest Rate
  • Credit
  • Liquidity
  • Reinvestment
  • Inflation

If you have questions about the risks of mortgage-backed securities, reach out to your financial advisor to discuss whether or not this investment type is best for you.

Ready To Invest In Mortgage-Backed Securities?

If you’re interested in investing in mortgage-backed securities we recommend calling upon an experienced team of financial experts.  The world of trading these bonds can be unwieldy and complex, so relying on the expertise of a company like Carty & Co. ensures that you’ll get the best advice and the best advice available within the broker/dealer community.

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