Mortgage-backed securities can be an appropriate choice for bond investors seeking a monthly cash flow, higher yields than Treasuries, generally high credit ratings, and geographic diversification.
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Mortgage-backed securities, also known as mortgage-backed bonds, are collateralized by mortgages, which are often residential mortgages. They’re created by pooling mortgages purchased from the original lenders. Investors receive monthly interest and principal payments from the underlying mortgages. Since the principal amount is generally paid down monthly, mortgage-backed securities differ from traditional bonds in that there isn’t necessarily a predetermined amount that gets redeemed at a scheduled maturity date.
Why would Schwab recommend mortgage-backed securities?
Investors who are looking for monthly income might want to explore the benefits of mortgage-backed securities, as they pay both interest and a portion of principal on a monthly basis. This return of principal can then be spent or reinvested in the current interest rate environment.
What are the different types of mortgage-backed securities?
Schwab offers three types of mortgage-backed securities, each of which are guaranteed by three government-sponsored enterprises (GSEs): Ginnie Mae, Fannie Mae, and Freddie Mac. The three different types are:
Government National Mortgage Association (GNMA)
Bonds guaranteed by Ginnie Mae are backed by the full faith and credit of the U.S. government. Unlike the other GSEs referenced below, GNMA does not purchase, package, or sell mortgages, but does guarantee their principal and interest payments.
Federal National Mortgage Association (FNMA)
Fannie Mae purchases mortgages from lenders, then packages them into bonds and resells them to investors. These bonds are guaranteed solely by Fannie Mae, are not direct obligations of the U.S. government, and do carry credit risk.
Federal Home Loan Mortgage Corporation (FHLMC)
Freddie Mac purchases mortgages from lenders, then packages them into bonds and resells them to investors. These bonds are guaranteed solely by Freddie Mac, are not direct obligations of the U.S. government, and do carry credit risk.
Take a closer look at the benefits.
Monthly cash flow
Investors receive a monthly payment, but the amount received each month consists of both interest and principal and may vary from month to month. The amount of interest paid each month is dependent on the amount of principal left in the underlying mortgage pool.
Mortgage-backed securities may be collateralized by mortgages from different parts of the country, so weakness experienced in the housing industry in one part of the U.S. may potentially be offset within the pool of mortgages.
Historically, mortgage-backed securities have provided yields that are higher than those for Treasuries of comparable maturities. This is mainly due to the uncertain nature of their cash flows and lower liquidity than Treasuries. Mortgage-backed securities issued by Fannie Mae and Freddie Mac are not explicitly guaranteed by the U.S. government and therefore carry more credit risk.
High credit quality
Most mortgage-backed securities are considered to have high credit quality. Ginnie Mae mortgage-backed securities are backed by the full faith and credit of the U.S. government and carry the same implied rating as U.S. Treasuries. Senior debt mortgage-backed securities issued by Fannie Mae or Freddie Mac are also highly rated, though they have no federal guarantee. In addition, agency mortgage-backed securities generally have higher credit quality when compared with other individual bond types, such as corporate bonds, because they are collateralized by an underlying pool of mortgages.
Mortgage-backed securities are subject to many of the same risks as those of most fixed income securities, such as interest rate, credit, liquidity, reinvestment, inflation (or purchasing power), default, and market and event risk. In addition, investors face two unique risks—prepayment risk and extension risk.
When mortgage rates fall, homeowners typically refinance more frequently and mortgage-backed securities tend to repay principal more quickly than originally anticipated. This can result in a shorter average life and a lower-than-expected return since investors receive the higher fixed coupon for a shorter period of time.
When mortgage rates rise, homeowners typically refinance less frequently and mortgage-backed securities tend to repay principal more slowly than originally anticipated. This can result in a longer average life and a lower-than-expected return since investors receive the lower fixed coupon for a longer period of time.
The risk that the value of a fixed income security will fall as a result of a change in interest rates. Mortgage-backed securities tend to be more sensitive to changes in interest rates than other bonds because changes in interest rates affect both the mortgage-backed bond and the mortgages within it. This risk can be reduced by diversifying the maturities and characteristics of mortgage-backed investments.
The risk that a security’s credit rating will change, resulting in a decrease in value for the security. The measurement of credit risk usually takes into consideration the risk of default, credit downgrade, or change in credit spread.
The risk that a security will not have significant demand, such that it cannot be sold without substantial transaction costs or a reduction in value.
The risk that when interest and principal payments are paid, interest rates will be lower, leaving the investor with lower yielding reinvestment options and a possible reduction in cash flow.
Inflation (or purchasing power)
The risk that inflation will erode the real return on investment. This occurs when prices rise at a higher rate than investment returns and, as a result, money buys less in the future.
Market and event risk
The risk that a change in the overall market environment or a specific occurrence, such as a political incident, will have a negative impact on the price/value of your investment.
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