What is Mortgage Bond?
The term “mortgage bond” refers tothe type of bond that is secured by a mortgage or a pool of mortgages, which is backed by collateral in the form of real estate property, equipment, etc. Typically, the lenders aggregate these mortgages and sell them to the investment banks who re-package the loans into securities and then again sell them to the interested investors. The monthly payments received by the investors include interest and principal payments made by the original borrower of the mortgage loan.
Explanation of Mortgage Bond
A mortgage bond offers the protection of the principal amount as it is secured by a valuable asset. Consequently, if the mortgage bond defaults then the bondholder has the right to sell off the underlying asset to compensate for the loss of payments. However, owing to this inherent security an average mortgage bond offers a lower yield as compared to traditional corporate bonds, which are backed by their ability as well as an implicit promise to pay.
How does Mortgage Bond Work?
In general, a bank holds a large number of mortgage loans on their books and some of them they don’t want to maintain until their maturity. In such a scenario, the bank can sell the mortgage loans to an investment bank or other similar institution, which could be a private, governmental or quasi-governmental entity, and get the liquidity to make other loans.
The investment bank then creates a pool of mortgages and groups them into securities with mortgages that exhibit similar characteristics, say same interest rates, maturity periods, etc. The investment bank can now sell the securities to interested investors in the open market. Once the securities are sold, the investment bank can then use the funds from the sale to purchase more mortgage loans and create more mortgage bonds.
The investors who purchase these bonds get their payments which comprise of the interest as well as principal payments for the underlying mortgages. In case the bond defaults, then the investors have the right to foreclose on the underlying collateral or asset.
Examples of Mortgage Bond
Let us take a simple example to understand the concept of a mortgage bond. Let us assume that 20 people borrowed a loan of $25,000 each at 5% while offering their house as collateral to the bank. So, the total mortgage loans in the bank book will be of $500,000. Now, the bank can sell this pool of mortgage to an investment bank and use the proceeds from the sale to make some fresh loans.
Now, the investment bank can group this pool of mortgage into 500 mortgage bonds of $1,000 each and sell them at 4% to the interested investors. In this case, the bank will pass on the interest and principal payment received to the investment bank after keeping its margin/fee (say 0.5% of the loan amount). Again, the investment bank will also keep its spread of 0.5% of the loan amount and pass on the remaining to the investor. So, every year each investor will receive $40 (= 4% * $1,000) in interest payment plus the principal amount, while the bank and investment bank will get $2,500 each on the overall mortgage pool.
How to Buy Mortgage Bond?
The interested investors can buy mortgage bonds through banks or authorized brokers at approximately the same fee as any other traditional bond, which would be in the range of 0.5% to 3% depending on the bond size and various other factors. In the US, the mortgage bonds are primarily issued by three agencies – Government National Mortgage Association (Ginnie Mae), Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Association (Freddie Mac).
Some of the major advantages of mortgage bond are as follows:
- These securities offer a higher return on investment as compared to treasury bonds.
- It also offers a higher risk-adjusted return as compared to other debenture bonds given that these bonds are backed by valuable assets.
- It exhibits low correlation with other asset classes, which in turn results into asset diversification.
- In case of defaults, a mortgage bond is a better investment option than any other bond as the bondholder has the right to sell off the collateral to compensate for its loss.
- Typically, the monthly payments in the case of mortgage bonds comprise of both interest as well as principal payment and hence it mitigates the tail risk to a large extent. Tail risk refers to the risk of the inability of the original borrower to repay the lump sum principal amount at the time of maturity.
Some of the major disadvantages of mortgage bond are as follows:
- These bonds offers a lower yield (please don’t confuse it with risk-adjusted return)as compared to debenture bonds.
- These securities attracted a lot of negative publicity during the subprime mortgage crises of 2008. The history states that mortgage bonds are only as good as the underlying assets and the original borrowers.
- The holders of mortgage bonds are always exposed to the risk of prepayment of the underlying loan, wherein the regular payments come to a sudden premature end. It usually happens in a market witnessing declining interest rates.
So, it can be seen that mortgage bonds are used by lenders to access more liquidity in order to make more fresh loans. Thus, in this way the cycle goes on where mortgage bonds create more money, which in turn results in more mortgage loans. Further, some of the banks employ the process of mortgage bonds either to reduce or transfer risk. Overall, mortgage bonds are an integral part of the banking and financial system.
This is a guide to Mortgage Bond. Here we also discuss the introduction and how does mortgage bond work? along with advantages and disadvantages. You may also have a look at the following articles to learn more –