Mortgage-backed bonds got a bad name during the 2008-09 financial crisis. They were a large part of how bad mortgages made by banks infected the entire financial system, threatening the stability and well being of all of us. Nevertheless, there is nothing particularly dangerous or devious about these instruments.
Essentially, these bonds are a way for investors large and small to participate in the usually superior interest rate returns available to mortgage lenders. These bonds are created when banks and other mortgage lenders package the mortgages on their books into securities and sell them to investors in the broad bond market. Most of these bonds are divided into subgroups, called tranches. Each tranche reflects a level of credit risk for that subset of mortgages in the bundle. Whether their underlying mortgages are risky or secure, these bonds effectively pass the payments made by the borrowers who take out the mortgages through to the holders of these mortgage-backed bonds.
You can buy mortgage-backed bonds directly through brokers or through mutual funds. Some mutual funds specialize in these bonds, while others include them in a broader selection of offerings. Although such bonds are similar to those described in this earlier post, they can have a special appeal for three reasons:
- Because mortgage borrowers usually pay higher interest rates than corporate borrowers, mortgage-backed bonds tend to pay higher yields than other bonds of comparable maturity and quality.
- The pass-through arrangements (mentioned above) pay out monthly, providing a more regular flow of income than conventional bonds, which usually pay semi-annually.
- Because mortgages pay down the principal on the loan in stages, bond owners also get part of their principal back with each payment, thus enriching the regular cash flow. (Most conventional bonds pay the principal back only when the bonds reach maturity.) The drawback with mortgage-backed bonds is that there is no further payment of principal at maturity.
These bonds do have one unique risk. When interest rates fall, many mortgage borrowers will take advantage and refinance. Just as with bonds that have “call provisions.” Bondholders get paid in full, but they miss the benefit falling rates have on bond prices. (For a discussion of call provisions and the price effects on bonds from falling interest rates, see this earlier post.) But even recognizing this drawback, the other advantages of mortgage-backed bonds give them a distinct appeal to many investors.
If you want to hold mortgaged-backed bonds in your portfolio but remain wary because of memories of the 2008-09 financial crisis, you might consider buying Ginnie Mae bonds. These mortgage-backed bonds are issued by the Government National Mortgage Association on behalf of the Federal Housing Authority (FHA) and the Veterans Administration (VA). The US government backs them, making them as safe from default as possible, and they pay a slightly higher yield than Treasury bonds. You can buy them directly from the US Treasury or through a broker in units of $25,000. Alternatively, you can buy into mutual funds that specialize in Ginnie Maes.