What Are Mortgage Bonds?
Public and private sector organizations issue bonds to raise capital. A bond is a loan from the bond holder to the bond issuer, who pays periodic interest and repays the principal or face value of the bond on maturity. The interest rate, also known as the coupon rate, is based on the face value. Mortgage bonds, which are also known as mortgage-backed securities, as well as corporate and government bonds are the three main sectors of the bond market.
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Facts
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Mortgage bonds are created by pooling together mortgages. Mortgage lenders sell pools of these mortgages to private entities, such as banks and other financial institutions, or to government agencies while continuing to service the mortgage and the home owner. The buyers of these mortgages then bundle these mortgages together into pools, and issue securities, or bonds, that represent claims on the mortgage principal and interest payments made by home owners. This process is known as securitization.
Issuers
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Most mortgage-backed securities are issued by the Government National Mortgage Association, Ginnie Mae; the Federal National Mortgage Association, Fannie Mae; and the Federal Home Loan Mortgage Corporation, Freddie Mac. Ginnie Mae mortgage bonds are backed by the U.S. government, which guarantees timely payments. Fannie Mae and Freddie Mac mortgage bonds also provide certain guarantees, but are not explicitly backed by the U.S. government. These two organizations were placed under U.S. federal government control after the 2008 financial crisis. Private sector financial institutions also issue mortgage bonds.
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Types
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The two most common types of mortgage bonds are pass-through participation securities and collateralized mortgage obligations. Pass-through bond holders receive a proportional share of all underlying mortgage principal and interest payments. In collateralized mortgage obligations, cash flows are pooled and structured into many classes of securities, known as tranches, and sold to investors. Each tranche has risk and return characteristics.
Yield
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Mortgage bonds have historically offered higher yields or returns than U.S. Treasuries and other government bonds because of the associated uncertainties, such as pre-payments. As interest rates fall, more home owners are likely to refinance their mortgages. In addition, most home owners tend to sell their homes within the first 10 years. In both cases, the mortgages are prepaid and the proceeds flow through to the investors. In a falling rate environment, which is usually associated with economic uncertainty, the investor may have to invest the proceeds at lower interest rates. To compensate for this uncertainty, a certain premium is built into the price and yield of mortgage bonds.
Considerations: Role of Bonds in a Portfolio
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Bonds provide fixed monthly income and portfolio diversification. Investors often turn to bonds during economic or market downturns because they are safer than stocks. However, as the 2008 financial crisis showed, when home owners start defaulting on their mortgage payments in large numbers, the bonds built on those mortgages also suffer.
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