What are mortgage bonds?
“Mortgage bonds, though typically attached to homes, can refer to equipment as well,” says Jim Pendergast, senior vice president of altLINE, a division of The Southern Bank Company in Birmingham, Alabama. “If the owner defaults on the mortgage, mortgage bond holders have a legal claim on the property.”
Some investors may invest in mortgage bonds to diversify their portfolios. They may also like mortgage bonds because the debt is secured by tangible real estate.
How does a mortgage bond work?
In many cases, mortgage lenders have a number of mortgages on their books. Because of this, they have expended capital, and while they’re receiving principal and interest payments, they might want to make a faster profit.
Banks and other lenders can package these mortgages into bond securities and then sell them to other investors, allowing them to raise more capital quickly without waiting for the full loan term to pass, explains Pendergast.
“Banks and mortgage agencies sell mortgages as bonds to investors, typically at a discount,” Pendergast says. “It’s then the responsibility of the investors to take over receiving payments for the loans.”
It’s important to note, however, that the interest on a mortgage bond can fluctuate, unlike other bonds, like government bonds, which have a fixed rate of return.
Also, a mortgage bond doesn’t come with a principal payment at the end of the term. With a more traditional government or corporate bond, investors receive regular interest payments and then a lump sum principal payment at the end of the term. With mortgage bonds, however, the payments made to bondholders include the principal plus interest.
How do bonds impact mortgage rates?
Mortgage rates are influenced by a variety of factors, including market conditions and the yield on 10-year Treasury notes. However, mortgage bond prices can also impact rates, explains Dan Green, CEO of Homebuyer, a mortgage lender for first-time buyers. In general, there’s an inverse relationship between mortgage rates and bond prices.
“Mortgage rates are based on the price of mortgage bonds,” Green says. “When bond prices rise, mortgage rates drop. When bond prices drop, mortgage rates rise.”
By paying attention to prices of mortgage bonds and other trends, it’s possible to get a general idea of where mortgage rates might be headed next — although there’s no foolproof way to predict the future of the economy or markets.
Who buys mortgage bonds?
A variety of investors can buy mortgage bonds, Green says, including pensions, funds and the government. The government, for example, buys mortgage bonds under corporations like Freddie Mac and then sells them to individual investors, Pendergast adds.
“People and institutions looking for a relatively conservative investment typically choose mortgage bonds,” Pendergast says.
Are mortgage bonds safe?
Like any investment, mortgage bonds come with varying levels of risk. When bought through a broker with Securities Investor Protection Corporation (SIPC) insurance, you can be reasonably sure that your money is protected from failure by the broker, although you’re not protected by losses from the bond or the fund the bond is included in.
“Well-priced mortgage bonds balance risk and return,” Green says. “Poorly priced mortgage bonds expose investors to higher risk.”
Pendergast points out, however, that a mortgage bond is still considered relatively safe. As a result of this safety, you’re likely to see a lower rate of return than you would see with a stock investment, which is considered riskier.
“Additionally, since mortgage bonds are typically bought through the government, they’re safer than many other investments,” Pendergast says.
Depending on your investment strategy and asset allocation goals, mortgage bonds may make sense in your portfolio. Mortgage bonds can provide a degree of safety and income to your portfolio and help you reach your goals. Carefully consider your own needs and risk tolerance, and consider talking to an investment professional before deciding how to proceed.