Mortgage backed Securities
With the general trend of interest rates decreasing over the last two decades and current rates at record low levels, yield hungry investors have bid fixed income securites to sky high levels. Apart from bonds, mortgage backed securities have become increasingly popular as they usually have a higher yield but still bring the level of security investors desire.
A mortgage backed security is created by a financial institution when it decides to sell part of its residential mortgage portfolio to investors. The mortgages are put into a pool and investors acquire a stake in these pooled securities by buying a portion. These units are referred to as mortgage-backed securities. In essence it is a security that entitles the owner to a share of the cash flows generated from the pool of residential mortgages.
The mortgages in a pool are generally guaranteed by a government related agency like the Government National Mortgage Association (GNMA) or the Federal National Mortgage Association (FNMA) which protects the investors against defaults. This is what makes the mortgage-backed securites sound like fixed income bonds issued by various levels of government.
However, a critical difference here is that the mortgages in the MBS pool have prepayment privileges that can be quite valuable to the home owner. US mortages usually last for 25-30 years but can be prepaid at any time. Prepayments can occur for several reasons, including one of the more popular these days; refinancing.
If interest rates decrease dramatically, the homeowner might decide to refinance at the lower rate or take equity out of their house. The mortgage might be pre-paid if the house is being sold. The pre-payment option is a risk to morgage backed security investors as when interest rates decrease, they might not keep getting the higher yields if homeowners continue to refinance to take advantage of the lower rates.
So a regular bond would still have the coupon rate from when it was issues, the "coupon rate" from a pool of mortgages can vary. This means that investors require a higher rate of interest on a mortgage backed security than on other fixed income securities to compensate for the prepayment options that have been written. Mortgage backed securities might be guaranteed by certain government institutions, but they do have risks. Interest rates, credit worthiness, foreign investments, currencies, securities lending, and derivatives can have impacts on the net returns for the investor.
In most cases, mortgage backed securities should be considered by investors who seek a regular income, are looking for a conservative portfolio mix and prefer low-to-medium investment risk. The risks associated with mortgage backed securities could dramatically increase if the rate of defaults on household mortgages increases sharply and the government has to issue its own debt to cover the payments.
