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Mortgage Bond: A Guide On What They Are And How They Work

Carey Chesney5-minute read
UPDATED: May 19, 2023

When it comes to places you can put your money, the possibilities are virtually limitless. 401(k)s, savings accounts, investment properties, checking accounts, cyber currencies, a jar buried in the backyard? Ok, maybe that last one is a stretch, but you get the idea. With such a variety of options, it can be hard to find the right place to store your cash.

A mortgage bond is one of these many options that appeals to a wide swath of investors due to its reputation for being a safe place to store and grow funds. If you're familiar with the primary mortgage market, you may already know how mortgage bonds work. If not, we’ve got you covered.

What Is A Mortgage Bond?

Mortgage bonds are a pool of mortgages that lenders can sell to real estate investors following a completed home sale. These bonds are secured by real property and government-sponsored enterprises.

Because mortgage bonds are backed by real property, they are often considered a low-risk investment. For example, if a homeowner stops paying their mortgage (foreclosure), the property can be sold to recover the debt. The sale of a mortgage usually occurs immediately after a home’s closing. When this happens, a mortgage is bundled with others, and shares of the bundle are sold to investors.

Investors can make money from mortgage bonds in a few ways that include collecting interest on mortgage payments and earning money from payments toward the principal balance. In addition, if a borrower defaults, investors can choose to foreclose on the home.

How Mortgage Bonds Work

Lenders rarely retain ownership of a mortgage that they issue when a borrower purchases their home. More likely, the lender secures mortgages into mortgage-backed securities (MBS) to sell in the secondary market, typically to investment banks or government-sponsored enterprises (GSEs).

Government-Sponsored Enterprise

A government-sponsored enterprise (GSE) is a financial service corporation created by the U.S. government in order to boost the flow of credit within the economy. The most notable of these GSEs are Fannie Mae and Freddie Mac, which assist the real estate market by helping investors and homeowners securely invest in real estate. Fannie Mae and Freddie Mac have a huge impact on the secondary mortgage market by providing this service. Without them, it would be very hard for members of the general population to invest in mortgage loans as a moneymaking strategy, and you probably wouldn’t be reading this article. Once a GSE is in possession of the mortgage it receives from a lender, it packages it within a pool of other loans and begins issuing bonds with the mortgages as the backing.

Types Of Mortgage Bonds

Like with most investment tools, there are different shapes and sizes. Let’s look at two types to help further your understanding of mortgage bonds.

  • Pass-through securities: A pool of securities that can be invested in as a whole and has some sort of collateral is a pass-through security. This means the principal and interest from the mortgage is passed through to the bondholder in full, after a fee is paid to the issue of the bond.
  • Collateralized mortgage obligations: Mortgage bonds are packaged in different, complex ways to meet varying investor risk and reward needs. Different packages can include different levels of prepayment risk, interest rate risk, reinvestment risk (how quickly the principal is paid down and the interest payments decrease) and default risk.

Mortgage Bond Example

As a mortgage bond example, let’s say 5 different people took out a $200,000 mortgage loan with an interest rate of 6% at the same bank (let’s call it Bank A). That’s a total mortgage value of $1,000,000. By selling mortgages to an investment bank (we’ll call that Bank B), Bank A can use the funds they receive to issue new loans to new borrowers. Bank B then sells $1,000,000 worth of bonds (1,000 bonds at $1,000 per bond).

They pay 5% interest for these bonds, creating a profit margin on the interest of 1% or $5,000.  They share this profit in the form of a fee to Bank A. As the five different homeowners pay their mortgages, Bank A, Bank B and the people who invested in mortgage bonds through Bank B all get a return on their investment.

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Mortgage Bond Pros And Cons

Armed with this knowledge, you may still be wondering, “Should I invest in the mortgage bond market?” Before any financial investment, it’s critical to look at both the benefits and potential drawbacks. So, let’s take a look at some of the pros and cons of investing in the mortgage bond market.

Mortgage Bond Advantages

  • Recurring payments: A steady flow of payments from homeowners can provide reliable and safe income for investors.
  • Homeowner defaults: Wait, it’s a pro when homeowners default on their mortgage? Yes, because bondholders can sell off a foreclosed property if this happens.
  • Liquidity: Money is easy to put in or take out.
  • Safer than stocks: Many investors believe mortgage bonds are safer investments than stocks because they are secured by real property and in some cases are backed by the U.S. government.

Mortgage Bond Disadvantages

  • Risk of loss: If a borrower pays off their loan early, interest payments stop. That means mortgage bond investors lose money.
  • Lower yields: Yields tend to be lower than other forms of investments like corporate bonds.
  • Inflation: Inflation means higher cost, higher interest rates and less mortgage borrowers. This means less ROI for mortgage bond holders. Inflation also reduces the demand that investors have for mortgage-backed bonds. As demand drops, the prices of mortgage-backed securities fall. That results in higher interest rates for all mortgage types.

Mortgage Bond FAQs

Hopefully you have a good understanding of mortgage bonds now. Just in case a few questions remain, here are some FAQs about mortgage bonds.

Do mortgage bonds still exist?

Yes! Mortgage bonds are still sold and purchased frequently. As long as they continue to be a safe and secure form of investment, their popularity should remain strong into the future.

How do bonds affect mortgage rates?

Many people wonder how bonds affect interest rates. The answer is that bond prices have an inverse relationship with mortgage interest rates. As bond prices go up, mortgage interest rates go down. As bond prices go down, mortgage interest rates go up.

This might leave you wondering how mortgage rates are determined. There are a number of economic factors, including the Federal Reserve, the bond market, inflation and the overall economy.

Are mortgage bonds high risk?

No, mortgage bonds are generally considered low risk since they are backed by mortgages and government entities.

What is the difference between a bond and a mortgage?

A mortgage is a loan from a lender to a borrower used to purchase a home. A bond is an investment sold to a bank, person or other entity by a lender.

The Bottom Line

When it comes to investments, you have a plethora of options. In most cases, it’s important to determine how much risk/reward tolerance you are looking for. In general, the higher the risk, the greater the reward (and possible loss). The safer the investment, the less likely you are to have big gains (or big losses). If you're looking to go the safe route, a mortgage bond might be a good place to start.

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Carey Chesney

Carey Chesney is a Realtor® and freelance writer that brings a wealth of experience as a former Marketing Executive in the fields of Health Care, Finance and Wellness. Carey received his Bachelor's in English at University of Wisconsin-Madison and his Masters in Integrated Marketing & Communications at Eastern Michigan University. You can connect with Carey at https://www.linkedin.com/in/careychesney/.