How Are Mortgages Different From Other Market Securities?
Investors can purchase securities that are obligations of a specific pool of mortgages. These securities are commonly known as mortgage-backed securities (MBSs), and several characteristics make them significantly different from other types of bonds.
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Time Frame
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Bonds typically have a fixed maturity date. Mortgage-backed securities will own part of a pool of mortgages that incur some payoff of principal as homeowners make their monthly payments, sell their homes or refinance their mortgages.
Payments
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Holders of mortgage-backed securities receive payments every month that include interest earned on the mortgages and a repayment of principal. Bond owners receive interest payments twice a year, and the principal is returned at maturity.
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Interest Rates
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When interest rates decline, many homeowners may elect to refinance their mortgages. Holders of mortgage-backed securities will have their principal returned early at a time when rates are lower. A regular bond will continue to pay the stated interest until maturity.
Derivatives
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Simple mortgage-backed securities are the straightforward pass-through of principal and interest as homeowners make mortgage payments. Derivative mortgage securities, called collateralized mortgage obligations (CMOs) or collateralized debt obligations (CDOs), divide a mortgage pool into different rates of principal and interest payment.
Potential
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Most mortgage-backed securities are guaranteed by the federal government or government agencies and have little or no credit risk. The interest paid by a mortgage-backed security can be significantly higher than that of a comparable Treasury bond.
Warning
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Derivative mortgage obligations are hard to analyze and have gotten some of the world's largest banks in financial trouble. Individual investors should stick with straight, pass-through mortgage securities.
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