Mortgage Bonds are secured by a mortgage or a pool of mortgages that are backed by collateral such as real estate property. The collateral backing makes mortgage bonds secured form of investment. The collateral can include both residential and commercial real estate properties.
Definition
A mortgage bond is secured by a mortgage that is typically backed by collateral such as real estate property.
The investors hold the rights to the pledged assets as collateral. If the borrower of the mortgage defaults, the bondholders keep the rights on the underlying security such as a home.
The investors receive monthly interest payments that include the principal portion as well. These bonds are considered safer investments due to collateral backing hence offer lower returns to investors. Unlike debentures, the mortgage bonds do not repay the principal amount at maturity. However, the security feature attracts investors to these bonds.
How Does Mortgage Bond Work?
Homebuyers get their houses through mortgages. These mortgages are backed by collateral such as the house or other real estate property. Banks do not keep the long-term mortgages with them. They can pool mortgages into securities that are marketable in the secondary market.
Investors can make quick returns on these marketable securities. Since these bonds are backed by collateral, they are considered safer investments. However, the same feature makes these bonds less profitable as they come with lower interest rates than debentures.
In the case of default by the borrowers, the bondholders keep the rights to the seizure of collateral. This way the risk of default shifts from banks to the bondholders. Since the mortgages are secured these mortgage bonds offer lower yields than conventional debentures.
Investment banks collect the repayments from mortgage loan borrowers. They pass on the interest plus the principal component to the bondholders and keep their portion. The difference arises mainly because these bonds enjoy collateral backing. Investors receive larger repayments as these arrangements include principal repayment as well.
Special Considerations with Mortgage Bonds
These bonds differ from debentures in some ways. In terms of financial security, rate of return on investment, and repayment terms are key differences between these bonds and debentures.
Here are a few key considerations to note with mortgage bonds.
Risk Factor in Mortgage Bonds
Typical mortgage bonds are backed by collateral. The borrowers pledge their houses to lenders, which in turn pledge them to investors in these bonds. That makes these bonds a secure investment. However, subprime mortgages come with higher risks. As seen in the past, the subprime mortgages caused the global financial crunch in the late 2000s.
Subprime mortgages are loans issued to borrowers with low or bad credit scores. These mortgages carry a higher risk of default, hence are riskier investments.
Floating Interest Rates
Unlike debentures, mortgage bonds come with floating interest rates. This factor carries an advantage and risks at the same time for the investors. These returns are offered as risk-adjusted returns, as the investments are backed by collateral. The investors receive repayments monthly in contrast to the debentures that repay annually or semi-annually.
Types of Mortgage Bond
Some of the common types of mortgage bonds include the Mortgage Passthrough Securities and Collateralized Mortgage-Backed Securities.
Mortgage Pass-through Securities
Each investor in a mortgage bond receives repayment according to their proportional investment. The investors also face the default risk up to their investment proportion. Hence, benefits and risks are proportioned in the mortgage pass-through securities.
Collateralized Mortgage-Backed Securities
In this arrangement, investors are classified. They receive returns and face risk according to their prioritization and classification. The investor with the highest priority faces lower default risks and the investor with the least priority faces the highest default risks.
Advantages of Mortgage Bonds
These Bonds have several advantages over debentures and other types of bonds.
- Mortgage Bonds are safer investments as they come with collateral backing. The investors hold the right to the seizure of pledged assets in case of default.
- These bonds offer frequent repayments in contrast to debentures that offer semi-annual or annual repayments.
- These bonds include interest and principal repayments that reduced the maturity risk of investment.
- They offer a higher yield than Treasury bonds.
- They come with the risk-adjusted return feature.
Disadvantages of Mortgage Bonds
Although considered safer than other bonds, mortgage bonds also offer some disadvantages.
- The safety feature with these bonds means lower investment returns.
- If the pool of mortgages includes subprime mortgages, it carries a notorious reputation as well as a higher risk of default.
- These bonds often come with floating interest rates that can change the investment returns in the long term.
Conclusion
Mortgage bonds are touted as a safer investment as compared to debentures. These bonds are backed by collateral. The investors receive frequent repayments including the principal portion and hold the rights to pledged assets for seizure in case of default.
