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What is Mortgage Bond?

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Explanation of Mortgage Bond

A mortgage bond protects the principal amount as a valuable asset secures it. Consequently, if the mortgage bond defaults, the bondholder has the right to sell off the underlying asset to compensate for the loss of payments. However, owing to this inherent security, an average mortgage bond offers a lower yield than traditional corporate bonds, which are backed by their ability and an implicit promise to pay.

How does Mortgage Bond Work?

In general, a bank holds many mortgage loans on their books, some of which they don’t want to maintain until their maturity. In such a scenario, the bank can sell the mortgage loans to an investment bank or other similar institution, a private, governmental, or quasi-governmental entity, and get the liquidity to make other loans.

The investment bank then creates a pool of mortgages and groups them into securities with similar characteristics, say, the same interest rates, maturity periods, etc. The investment bank can now sell the securities to interested investors in the open market. Once the securities are sold, the investment bank can use the funds from the sale to purchase more mortgage loans and create more mortgage bonds.

Examples of Mortgage Bond

Let us take a simple example to understand the concept of a mortgage bond. Let us assume that 20 people borrowed a loan of $25,000 each at 5% while offering their house as collateral to the bank. So, the total mortgage loans in the bank book will be $500,000. Now, the bank can sell this pool of mortgages to an investment bank and use the proceeds from the sale to make some fresh loans.

Now, the investment bank can group this pool of mortgages into 500 mortgage bonds of $1,000 each and sell them at 4% to interested investors. In this case, the bank will pass on the interest and principal payment received to the investment bank after keeping its margin/fee (0.5% of the loan amount). Again, the investment bank will keep its spread of 0.5% of the loan amount and pass on the remaining to the investor. So, every year each investor will receive $40 (= 4% * $1,000) in interest payment plus the principal amount, while the bank and investment bank will get $2,500 each on the overall mortgage pool.

How to Buy a Mortgage Bond? Advantages

These securities offer a higher return on investment as compared to treasury bonds.

It also offers a higher risk-adjusted return than other debenture bonds, given that valuable assets back these bonds.

It exhibits a low correlation with other asset classes, resulting in asset diversification.

In case of defaults, a mortgage bond is a better investment option than any other bond, as the bondholder has the right to sell off the collateral to compensate for its loss.

Typically, the monthly payments in the case of mortgage bonds comprise both interest and principal payment and hence it mitigates the tail risk to a large extent. Tail risk refers to the risk of the inability of the original borrower to repay the lump sum principal amount at the time of maturity.

These bonds offer a lower yield (please don’t confuse it with risk-adjusted return) than debenture bonds.

These securities attracted a lot of negative publicity during the subprime mortgage crisis in 2008. History states that mortgage bonds are only as good as the underlying assets and the original borrowers.

The holders of mortgage bonds are always exposed to the risk of prepayment of the underlying loan, wherein the regular payments come to a sudden premature end. It usually happens in a market witnessing declining interest rates.

Conclusion

So, it can be seen that lenders use mortgage bonds to access more liquidity to make more fresh loans. Thus, in this way, the cycle goes on where mortgage bonds create more money, resulting in more mortgage loans. Further, some banks employ the process of mortgage bonds to reduce or transfer risk. Overall, mortgage bonds are integral to the banking and financial system.