Financial markets can be tricky. Unease usually leaves traders searching for a way to shield their investments. Should they continue to buy stocks at low price points? Maybe. Should they wait and see where the markets head next? That’s valid too. It’s a tough decision when it comes to your hard-earned money.
In times of economic turmoil, experienced investors diversify their portfolios to protect their investments. Exchanging some of the high risk/high reward investments for more stable securities is a popular way to do so. But what kind of securities are we talking about? Today, it’s mortgage bonds.
If you’re looking to diversify your portfolio, a mortgage bond could be a great addition. What is a mortgage bond? Let’s take a look.
What is a Mortgage Bond?
Most of us are familiar with mortgages. The majority of homebuyers take them out to fund the purchase price of new homes. The most common type is a first mortgage. It’s used to fund the purchase of the home. If the home needs a total renovation, they will take out a second mortgage. First mortgages typically involve hundreds of thousands of dollars, and represent decent sized investments, even for lenders.
When borrowers take out a mortgage loan, the lender has that much less liquid cash at their disposal. Lenders could collect the monthly payments and make a little on interest each month, but most don’t. Instead, they bundle mortgages together and resell them as a mortgage bond. To define mortgage bonds, first we’ve got to talk about what a bond is.
What is a Bond?
A bond in real estate is a debt security. More specifically, it is a fixed income security. When borrowers take out loans, they agree to pay principal and interest on that loan. If the lender chooses to make money off the interest, the reduced cash flow means less money to lend. In order to bankroll additional loans, they bundle these loans into securities for sale to third parties. The resulting security is known as a bond.
Bonds work very much like loans. In this case, the bank or other lending institution is the borrower. The loan is provided by investors, who collect regular payments of principal and interest. When you invest in mortgage bonds, you are essentially loaning the bank money to continue lending. This allows them to make more money.
Once lenders bundle the mortgages together as securities, they are then sold. Usually to an investment bank or government-sponsored enterprise (GSE) like Fannie Mae or Freddie Mac. In turn, these organizations may bundle the mortgages with even more mortgages. Those bundles are then segmented and sold as bonds to investors.
The two types of mortgage bonds are pass-through securities and collateralized mortgage-backed securities.
This is the most common type of mortgage bond. Sometimes called pay-through securities, pass-through securities are pools of fixed income securities that are backed by a package of assets. In the case of mortgage bonds, this package of assets includes the properties the mortgage bond is composed of. If the borrower defaults on the loan, the properties may be sold off to recoup the investment.
The lender, usually a bank, collects monthly payments from borrowers and passes the interest on to investors. At loan maturity, the remaining principal and interest are paid out. The bank makes money by originating the loans and taking a cut of the interest.
Collateralized Mortgage-backed Securities
The other type of mortgage bond you will encounter is the centralized mortgage-backed security. It’s also called a collateralized mortgage obligation, or CMO. A CMO is essentially a pass-through security that is broken up into tranches or portions. The tranches are differentiated by ratings and interest rates.
When borrowers make their monthly payments, investor payouts are distributed among the tranches. Each carries its own interest rate. For those that are nearing maturity and represent low risk, the interest payments are lower. That’s because there is little risk of default. For loans that present more risk, investors are compensated for taking on that additional risk through higher interest rates.
What are Bond Loans?
When people hear “bond loan,” it can cause some confusion. It’s a little different from a traditional mortgage loan or mortgage bond. A bond loan is a mortgage loan that is funded by the sale of the bond. Basically, the lender finds someone to share the risk before issuing the loan. Along with subprime mortgages, bond loans can be ideal options for those with poor creditworthiness.
Benefits of Mortgage Bonds
If you’re wondering why someone would want to buy a loan off a bank, you’re not alone. Anyone who’s never heard of mortgage bonds could understandably have a hard time understanding their purpose. Rest assured, there are a number of great benefits that go along with buying and selling mortgage bonds.
Benefits to Borrowers
The first group that benefits from mortgage bonds is the borrower. Mortgage bonds allow them to borrow large amounts of cash at reasonable costs. People who otherwise couldn’t afford homeownership are given a shot at the American Dream. If not for mortgage bonds, banks may decide to invest their money elsewhere in hopes of higher rates of return.
Benefits to Lenders
Borrowers aren’t the only ones benefiting from mortgage bonds. Lenders and investors get some great benefits from them too. Here’s how.
First, mortgage bonds provide liquidity to the bank. Sitting on mortgages means they have less money to lend. Selling them second hand provides more money for lending, and they still get paid through loan origination and servicing.
Second, mortgages are backed by real assets, so lenders can recoup any losses in the case of a default. Even if there is a default on the loan, that risk is largely transferred to investors. This relative security makes mortgage bonds a fairly safe investment for lenders.
Benefits to Investors
A mortgage bond allows investors, also called bondholders, to get into the real estate game at lower price points. That’s a great gateway for those just getting started. Another benefit to investors is that they don’t have to buy or sell home loans themselves. They get to invest their money, and let experts handle the technical aspects. Investors earn money on mortgage bonds in two main ways.
Appreciation - Like all investment securities, the value of a mortgage bond can fluctuate. If investors hold onto them and sell when the market is right, they can make a decent profit.
Regular Interest Payments - As borrowers pay off their principal and interest every month, a portion of that interest is distributed among investors. This provides a steady stream of income.
There is also little correlation between mortgage bonds and many other asset classes. This makes getting into mortgage bonds a solid way to diversify an investor’s portfolio. A mortgage bond is also considered a much safer investment than a corporate bond. As a result, the rate of return is going to be lower due to that relative safety.
Downsides of Investing in Mortgage Bonds
Even with all the advantages of investing in mortgage bonds, there are some downsides. Before deciding on whether or not mortgage bonds are right for you, you should know some of those downsides.
Relatively Low Rate of Return
Low risk investments with lower rates of return are integral parts of a long term investment strategy. However, that lower rate of return may also be negated by inflation. If the rate of inflation exceeds the rate of return on your investment, you may not make much profit. Mortgage bonds are best used as a long term investment that provides a steady stream of income.
Risk of Default
No investment is completely free of risk. With mortgage bonds, the risk is that the borrowers fail to make their monthly payments. If the loans default, there is a chance that selling the properties doesn’t fully recoup the lost principal investment. Luckily, there are some pretty stringent rules imposed on lenders, so the risk is minimized.
Know Your Options
Before making any type of investment, it’s important to know what you’re getting into. If you don’t know all the ins-and-outs of a particular investment, make sure you talk to a financial professional. They can provide insight into the risks and rewards of each.
Don’t know how bonds affect mortgage rates? Another great reason to talk to a mortgage bond professional. They may even be able to fill you in on things like current mortgage rates, housing market conditions, and inflation. All these things will have an effect on whether or not the time is right to get into mortgage bonds.