Mortgage Bond

A mortgage bond refers to a bond issued to the investor which is backed by a pool of mortgages secured by the collateral of real estate property (residential or commercial) and, therefore, makes the borrower pay a predetermined series of payments, failure of which may lead to sale or seizure of the asset.

The investors receive a monthly payment that includes interest as well as the principal amount when the borrower pays interest and repayment of debt to the person who borrowed money by keeping some real estate assets as collateral. In case the borrower defaults, the asset can be sold to pay off bondholders secured by those assets.

• A mortgage bond is issued to an investor and is backed by a pool of mortgages secured by real estate property, whether residential or commercial. This bond requires borrowers to make a predetermined number of payments. Failure to meet these payments could lead to the property's sale or seizure.
• Mortgage-backed securities (MBS) come in various forms, including Collateralized Mortgage Backed Securities (CMBS) and Mortgage Passthrough Securities.
• Mortgage bonds offer benefits such as diversification, better yields compared to Treasury bonds, and lower risk than debenture bonds. 

Mortgage bonds as an asset class offer diversification and offer the investor a higher yield than the treasury and lower risk than debenture bonds. Moreover, they provide money to investment banks to purchase more mortgages and lend more money, which helps keep mortgage bond rates competitive and markets liquid.

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 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 is passed every month to mortgage bondholders. An investment bank keeps its share in the interest component of a loan and passes on the rest of the interest plus the principal component to bondholders. This process of pooling mortgages and passing cash flow on debt to bondholders is called securitization.

When investing or dealing in such bonds, the investors, be it individual or institutional, have two mortgage bond markets to look up to. One is the primary market where bonds are issued by banks or financial institutions that pool the mortgages and sell bonds to investors. This is where the legal compliances are taken care of. Another one is the secondary market where the investors can purchase and sell these bonds. These transactions ensure the market remains active and liquid.

Additionally, the mortgage bond prices are affected by various factors, including interest rates, credit quality of the underlying mortgages, government policies, economic conditions, etc.

There are various types of it found in the mortgage bond market. Let us explore them in brief:

Residential mortgage bond is a bond backed by residential property, exposing investors into the real estate market dealing with apartment buildings, and other residential options. These involve comparatively lower risks.

Commercial mortgage bond is a bond backed by commercial properties, which includes premises where commercial activities are carried out. The loan amounts are higher and hence the risk related to these mortgage bond deals are more.

Government bonds are the mortgage instruments that are guaranteed against the mortgages backed by government authorities and agencies.

Lastly, it is hybrid mortgage bond that exhibit the feature of both residential and commercial mortgage bonds. They allow investors to have a diversified portfolio spread across different real estate markets. This type, providing a diversified portfolio option, offers a balanced risk profile. Furthermore, the types can be subdivided into adjustable-rate mortgages and reverse mortgages.

Tranches

In addition to the types of mortgage bonds, there are types of tranches of mortgage-backed securities that must be known to investors, given the mortgage bond being a vital part of MBS.

Let us check the four tranches, then the 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 one is fully paid, it will receive all the principal amount and prepayments until the principal balance is zero.
• Tranche 3 - After tranche two is fully paid, it will receive all the principal amount and prepayments until the principal balance is zero.
• Tranche 4 - After tranche three 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 shock absorbers if the 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 absorb losses in case of default.

Let us consider the following examples to understand the mortgage bond definition better and also see how it works:

Example 1

Suppose ten people took out 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 amounts to an investment bank XYZ and use that money to make new 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 the payment component in 1^st 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 1^st month to XYZ is $4500 plus the 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 the $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 new loans. In case of default by homeowners, the mortgage could be sold to pay off investors.

Example 2

In September 2023, the financial services company Intercontinental Exchange came up with a new research product to help gauge the losses likely to arise from climate change. This product is supposed to measure the climate risks associated with mortgage bonds, be it residential or commercial.

Mortgage bonds are quite beneficial for investors and entities. Not only do these instruments give borrowers with not-so-good credit score to participate in the market transaction using their real estate properties as a security that could be foreclosed in case, they default on repaying lenders.

Some of the benefits of mortgage bond include the following:  

• It offers a higher return than Treasury securities. and 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 payments.
• It is a safer investment than debenture bonds in case of default, and the collateral can be sold to pay off bondholders.
• This option 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. In other bonds, there is a high tail risk because of the lump-sum principal payment at maturity, which increases the risk to bondholders.

Despite the best advantages that it offers, it is important to know where it falls short. Some of the loopholes of these instruments are as follows:

• It offers a lower yield than debenture bonds.
• It is, often touted as a safe investment, attracted negative publicity due to its role in the 2008 subprime mortgage crisis. 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 the bankruptcy of many large investment banks like the Lehman brothers. So these bonds are as good as the asset, and people borrow money from 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.

The two types of financial instruments that are widely sought-after in the market are mortgage bond and debenture bond. When choosing one, it is important that individuals and entities learn about the differences between the two beforehand. Listed below are the main differences between mortgage and debenture bonds. Let us have a quick look at them:

• The bond is not secured and is backed only by the full faith and credit of the issuing company. In contrast, the mortgage bond is backed by collateral, which can be sold if the 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, which includes only the interest component, and the principal amount is paid at maturity.
• A good credit score is a must for individuals and entities as it would ensure bond issuers that the bond payment terms will be met. On the contrary, mortgage bonds being collateral based do not need bond seekers to have good credit history or score as the lender has a property to foreclose in the event of consequent defaults.

Mortgage bond, loan and mortgage-backed securities (MBS) are interrelated. This interrelation indicates how they differ despite coming from the same source.

MBS and mortgage bonds are confusing terms as both of them are collateral-based instruments. However, one must be aware that the latter is just a form of the former with a few sets of differences.

Mortgage bonds and finances are offered by the banks without the latter retaining the ownership of them. The lending institutions securitize these mortgages and convert them into financial products that can be transacted in the secondary market, thereby becoming mortgage-backed securities or MBSs.

This has been a guide to what is a Mortgage Bond. We explain its examples, vs mortgage-backed security, types, vs debenture bond, advantages & disadvantages. You can learn more about finance from the following articles –

• Fixed-Rate Mortgage
• Bullet Bond
• Bond Ladder
• Bond Fund Example