What is a Mortgage Bond?

A mortgage bond is a type of investment security. Bonds are a type of security in which the issuer owes a debt and is obliged to provide cash flow to the creditor. In the case of a mortgage bond, these bonds are secured by a mortgage or pool of mortgages and backed by real estate holding or property. Mortgage bonds are typically considered lower risk than corporate bonds and usually have lower interest rates. Read on to understand mortgage bonds as an investment opportunity. 

Understanding Mortgage Bonds

When a person buys a home with a mortgage, the mortgage becomes a debt instrument. Mortgage lenders typically sell the mortgage on the secondary market to an investment bank or government-sponsored enterprise (GSE). 

If you get a mortgage backed by Freddie Mac or Fannie Mae, these government entities will purchase the mortgage from the lender, bundle it with other mortgages and sell it on the secondary mortgage market. The mortgages are pooled with other loans and bonds with the mortgages as backing.

Then, when the homeowners connected to the individual mortgages pay their mortgage principal plus interest, the interest is used to pay the mortgage bond yields. By pooling many mortgages together, investors mitigate risk. As long as most homeowners make their payments on time, a mortgage bond is a reliable, lower-risk, income-producing security.

Mortgage bonds are a collateralized debt obligation considered a secure investment because the principal is secured by an asset — the properties purchased with the mortgage — of real value.

In case of default, mortgage bondholders could sell the underlying property to compensate for the default and secure dividend payments. In practice, this rarely happens, as mortgage bonds are lower-risk investments backed by more than a company's promise of repayment. For that reason, mortgage bonds are a solid lower-risk option within a diversified investment portfolio. 

How Does a Mortgage Bond Work?

You can purchase mortgage bonds on major financial markets. They are considered a good addition to a diversified, risk-balanced investment portfolio. Costs and maturity vary by bond offering. 

Bond prices and returns are expressed in par or face value and coupon. For example, you could buy a five-year bond for $1,000 (its par value) with a yield of 5%. That means the coupon amount you'll receive back is $50 annually if you hold it to maturity.

In most cases, bonds are expressed as a percentage of their face value. For example, a bond with a price of 95 is priced at 95% of its face value. 

Mortgage Loans vs. Mortgage Bonds: What’s the Difference?

A mortgage loan is offered to an individual consumer or family to purchase a property. The best mortgage lenders offer customized loan products to meet consumers' needs, from first-time homebuyers or self-employed individuals to specialty mortgages like interest-only mortgages,  mortgage buydowns or jumbo loans.

In contrast, a mortgage bond is a bundle of individual mortgages that can be bought and sold on financial markets as investments. These income-producing securities are considered a lower-risk investment for portfolio diversification.

Government-Sponsored Enterprises and Mortgage Bonds

A government-sponsored enterprise (GSE) is an entity established by the government to promote trade or industries. Instead of loaning money to the public, GSEs guarantee third-party loans to increase liquidity. In the case of mortgage bonds, this allows banks and mortgage lenders to offer more loans without risking liquidity issues. 

In the mortgage industry, the GSEs are Fannie Mae and Freddie Mac. These entities back mortgages that meet certain criteria from third-party lenders and then buy and bundle these loans into securities that can be bought and sold on the finance markets. Through this process, lenders recoup the funds from the mortgage to provide more credit to borrowers or mortgagors. 

Who Should Buy Mortgage Bonds?

Mortgage bonds are considered a low-risk investment. For that reason, investors seeking safety and a reliable source of income can use mortgage bonds. They're considered more secure than corporate bonds because they are backed by real assets. Some investors prefer mortgage bonds over Treasury bonds for their reliable returns.

Likewise, investors who want both the potential for long-term gains with regular monthly payments via interest often choose mortgage bonds. Each time a homeowner pays their mortgage plus interest, the interest is passed on to investors.

Pros of Mortgage Bonds

There are significant benefits to mortgage bonds, including:

• Low risk: While all investments carry risk, because of the physical asset backing and the bundled mortgages, mortgage bonds are considered low-risk investments. Even if a homeowner defaults on a loan, investors are protected by collateral. 
• Consistent returns: Mortgage bonds usually pay monthly returns that can be reinvested to build your portfolio faster. 
• Increase mortgage liquidity: Mortgage-backed securities help banks liquidate loan portfolios to offer more loans to new borrowers. 

Cons of Mortgage Bonds

The disadvantages of mortgage bonds are mainly that you'll find other investments with higher returns. Here are the cons: 

• Low yields: When compared to corporate bonds, or other securities like stocks or index funds, mortgage bonds have significantly lower average returns. 
• Risk: Although low-risk, mortgage bonds aren't without risk. As with any other investment, they should be incorporated in a diversified, risk-balanced portfolio to mitigate risk.  
• Inflation-related losses: In times of high inflation, mortgage bonds' returns may not outpace inflation. 

Should You Invest in Mortgage Bonds?

Mortgage bonds play a crucial role in liquidity for mortgage lenders, allowing more borrowers to qualify for a mortgage and become homeowners. The government-sponsored enterprises Fannie Mae and Freddie Mac play a crucial role in the mortgage markets, creating mortgage bonds that can be traded on secondary markets. 

Mortgage bonds present an option for investors to gain regular returns while mitigating risk. Whether you should invest in mortgage bonds depends on your financial goals. However, for many investors, mortgage bonds play a key role in a diversified portfolio. If you're looking for other investment options, consider the best bond funds or bond exchange-traded funds (ETFs).

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