Mortgage Bond Meaning
Mortgage bond refers to a bond issued to investor which is backed by a pool of mortgages secured by collateral of real estate property (residential or commercial) and therefore, makes the borrower pay predetermined series of payment, failure of which may lead to sale or seizure of the asset.
The investors receive a monthly payment that includes interest as well as principal amount when the borrower pays interest and repayment of debt who borrowed money by keeping some real estate assets as collateral and in case the borrower defaults, the asset can be sold to pay off bondholders secured by those assets.
How does Mortgage Bond Works?
When a person purchases a home and finances it by keeping it as a mortgage, the lender gets the ownership of that mortgage until the loan is fully paid. The lender includes banks and mortgage companies that give a loan on such real estate assets. Banks then club these mortgages and sell them to an investment bank or any government entity at a discount. This way banks get money instantly that they originally would get over the term of a loan and they also manage to shift the risk of any default from themselves to investment banks.
An investment bank then transfers that bundle to an SPV (special purpose vehicle) and issues bonds on those loans which are backed by the mortgage. The cash flow from these loans is in the form of interest plus principal payment is passed every month to mortgage bondholders. This process of pooling mortgages and passing cash flow on debt to bondholders is called securitization. An investment bank keeps its share in interest component of a loan and passes on the rest of the interest plus principal component to bondholders.
There are various types of MBS (mortgage-backed security)-
#1 – Mortgage Passthrough Securities
Under this type of MBS, payments are made proportionally among bondholders as they are received. If the total bonds issued are 1000 of $1000 each and there are 10 investors holding 100 bonds each, then, each investor would receive 1/10th of the payment passed on to them. Each investor would get its share of payment according to their holding. If there are prepayments, it will be passed on to bondholders proportionally. No bondholder would get more or less than his proportion of total bond holding in those mortgages. In the case of default, every investor would bear the loss (if the asset value falls below the face value of bonds) to his proportion in bonds.
So the MPS investors or bondholders face both prepayment and extension risk equal to their holdings.
#2 – CMBS (Collateralized Mortgage Backed Security)
We have seen above how MPS investors face prepayment risk and in the eventuality of prepayment how every investor receives it irrespective of whether they need or prefer it at that time. Many investors are concerned with prepayment and default risk.
CMBS helps in mitigating these problems by directing the cash flows from mortgages to different classes or layers called tranches so that every class has different exposure to both risks. Each tranche is governed by a different set of rules on how the payment is to be distributed. Every tranche receives interest payment every month but the principal and prepayment amount are paid sequentially. CMBS is structured in such a way that each class of bond would retire serially in order.
If there are 4 tranches, then rule for monthly principal and prepayment to the tranches would be as follows –
- Tranche 1 – Would receive all the principal amount and prepayments until the principal balance is zero.
- Tranche 2 – After tranche 1 is fully paid; it will receive all the principal amount and prepayments until the principal balance is zero.
- Tranche 3 – After tranche 2 is fully paid; it will receive all the principal amount and prepayments until the principal balance is zero.
- Tranche 4 – After tranche 3 is fully paid, it will receive the principal amount and prepayments until the principal balance is zero.
So this way, prepayment risk is distributed among tranches. The highest prepayment risk is in Tranche 1, whereas lower tranches act as a shock absorber in case borrower defaults. In the above example, Tranche 4 has the highest default risk and lowest prepayment risk as it gets prepayment after the above three tranches are fully paid and get to absorb losses in case of default.
Suppose 10 people took a loan of $100,000 at 6%each by keeping the house as collateral in ABC bank totaling a mortgage of $1,000,000. Bank would then sell this pool of mortgage amounting to an investment bank XYZ and use that money to make fresh loans. XYZ would sell bonds of $1,000,000 (1000 bonds of $1000 each) at 5% backed by these mortgages. ABC bank would pass on the interest received ($5,000) plus payment component in 1st month to XYZ after keeping a margin or fee. Let’s say the fee kept is 0.6% (0.05% monthly) of the loan amount, so the amount passed on 1st month to XYZ is $4500 plus repayment amount. XYZ would also keep its spread of 0.6% (0.05% monthly)on the loan amount and pass on the rest of the interest of $4000plus repayment amount the first month to mortgage bondholders.
This way the investment bank can purchase more mortgages from a bank through money received from selling bonds and the banks can also use money received from selling mortgages to make fresh loans. In case of default by homeowners, the mortgage could be sold to pay off investors.
Mortgage vs Debenture Bond
The main difference between debenture and mortgage bond is that the debenture bond is not secured and is backed only by the full faith and credit of the issuing company, whereas the mortgage bond is backed by the collateral which can be sold in case borrower defaults. Therefore the interest rate of MBS is lower than debenture bonds due to lower risk.
The other difference lies in the payment and frequency of payment. Mortgage bonds are paid monthly and include interest as well as a principal component. Debenture bonds, on the other hand, are paid annually or semiannually that includes only interest component and the principal amount is paid at maturity.
- Mortgage-backed securities offer a higher return than Treasury securities.
- It offers higher risk-adjusted returns than other debenture bonds due to the backing of mortgaged assets which reduces its risk.
- They provide asset diversification as they have a low correlation with other asset classes.
- It provides regular and frequent income as compared to other fixed-income products. MBS has monthly payments whereas corporate bonds offer annual or semiannual payment.
- A mortgage-backed security is a safer investment than debenture bonds as in case of default, the collateral can be sold to pay off bondholders.
- MBS does not have tail risk as there is no lump sum principal payment on maturity because monthly payment involves interest plus principal component which is spread over the life of a bond. Whereas in other bonds there is a high tail risk because of the lump-sum principal payment at the maturity which increases the risk to bondholders.
- Mortgage-backed security offers a lower yield than debenture bonds.
- Mortgage-backed security often touted as safe investment attracted negative publicity due to their role in the 2008 subprime mortgage crises. Banks due to high profitability became complacent and issued loans to people having low creditworthiness. When subprime mortgages defaulted, it resulted in the loss of millions of dollars of investors money and bankruptcy of many large investment banks like Lehman brothers. So these bonds are as good as the asset and people borrowing money on those assets.
- Such bondholders face the risk of prepayment in case of a lowering of interest rate in the market. Moreover, the money received by them will have to be invested at a lower rate which reduces their return.
Mortgage bonds as an asset class offer diversification and offer the investor with a higher yield than treasury and lower risk than debenture bonds. Moreover, they provide money to investment banks to purchase more mortgages and banks to lend more money which helps in keeping mortgage rates competitive and markets liquid.
This has been a guide to Mortgage Bond and its Meaning. Here we discuss the types of mortgage bond along with an example, advantages, disadvantages, and its differences from debenture bond. You can learn more about finance from the following articles –