Make More with Mortgage-backed Securities
By Gene Walden
(Excerpt from If Not Stocks What?)

Good income, low risk

Mortgage-backed securities are fixed-income investments that generate interest revenue through pools of home loan mortgages. Sometimes referred to as MBS or "pools" or "mortgage pass-through certificates," mortgage securities are an excellent source of current income. Although they don’t have quite the safety of government-backed Treasury issues, mortgage-backed securities are very safe, and they pay interest rates slightly higher than Treasury issues and many investment grade corporate bonds.

MBS investors own an interest in a pool of mortgages that serve as the underlying asset for the MBS. When homeowners make their monthly payment of interest and a small share of the principal, that money is passed through to the MBS investors or "certificateholders."

Most mortgage-backed securities are issued by three primary agencies, the Government National Mortgage Association (Ginnie Mae), the Federal Home Loan Mortgage Association (Freddie Mac), and the Federal National Mortgage Association (Fannie Mae). A small number of MBS issues are sold by other lending agencies.

Unlike Treasury issues and municipal bonds, mortgage-backed securities offer no tax benefits. They are fully taxable by state, local, and federal governments. And while Treasury security investors receive interest payments twice a year, MBS investors receive checks every month.

Although home loan mortgage pools are the most common type of MBS, there are other classes of securities similar to mortgage-backed securities but tied to other types of loans. For instance, you might find securities tied to pools of credit card loans, car loans, mobile home loans, college loans, or other types of loans.

In addition to the standard type of MBS, there are several offshoot investments derived from mortgage-backed securities, including:

• CMOs. Collateralized mortgage obligations (CMOs) break up mortgage pools into separate maturity categories called "tranches." Each CMO is a set of two or more tranches, each with average lives and cash-flow patterns designed to meet specific investment objectives. One CMO might have four tranches with average life expectancies of two, five, seven, and 20 years. That gives investors a wider array of options. Some CMOs have several dozen tranches. The system helps cut back on the early prepayment of mortgages, which is one of the biggest drawbacks of the MBS market. With CMOs, all prepayments from underlying mortgages are applied to the first tranche until it is paid off. Then prepayments are applied to the next tranche until it is paid off, and the process continues until all the tranches are eventually retired. The concept gives investors the ability to choose a tranche that fits their maturity time frame.
• REMICs. Real estate mortgage investments conduits (REMICs) are similar to CMOs with a twist. While CMOs separate mortgage securities into maturity classes, REMICs also separate them into risk classes. A REMIC may have a pool of higher risk or even distressed mortgages, so the risk is higher, but the yield is higher as well. REMICs are the junk bonds of the mortgage-backed securities category.
• STRIPs. Mortgage-backed securities may be stripped of their interest coupons and sold as zero coupon bonds. Rather than make regular monthly interest and principal payments, STRIPs pay all the principal and compounded interest in one lump sum at maturity.

For investors looking for a steady stream of income at a higher interest rate than most government bonds pay, mortgage-backed securities provide an appealing option.

Who should buy Mortgage-backed Securities?

Mortgage-backed Securities are ideal for investors interested in safety and income. More aggressive investors might also want an MBS for the portfolio to provide diversification. MBS’s offer no tax benefits, so they would be appropriate for tax-sheltered retirement plans.

Who should not buy MBS’s?

Mortgage-backed securities would not be appropriate for investors interested in capital appreciation—unless you buy zero coupon securities. Aggressive investors looking for a high level of income might also shy away from MBS’s, although they are among the higher-yielding types of fixed income investments.

Return

Mortgage-backed securities are considered very safe. They are guaranteed by the issuer, and since they are made up of pools of mortgages, their return is not based on a single mortgage holder.

Ginnie Mae securities are technically the safest of all MBS options because they are guaranteed by Ginnie Mae, which is a wholly owned government corporation backed by the full faith and credit of the United States.

Securities issued by Fannie Mae and Freddie Mac are also guaranteed, but not by the full faith and credit of the U.S. government. Fannie Mae and Freddie Mac are publicly traded corporations (you can buy stock in either company on the New York Stock Exchange) originally set up by the U.S. Congress. They guarantee the timely payment of all principal and interest of the mortgage-backed securities they issue. Although their guarantee doesn’t carry the weight of the U.S. government, Freddie Mac and Fannie Mae are two of the most fiscally sound corporations in America. Their mortgage-backed securities are considered to be the equivalent of AAA-rated corporate bonds. They have never defaulted on a mortgage-backed security.

Upside

There are several important benefits of owning mortgage-backed securities. Safety and a steady stream of income are the most obvious, but there are some other benefits, as well, such as:

• Excellent interest rates. The interest they pay is higher than the rate offered by other government bonds and most investment grade corporate bonds.
• Liquidity. There is a huge secondary market for mortgage-backed securities, so you can buy and sell them whenever you wish. If you don’t want to hold them through maturity, it’s easy to find a buyer on the secondary market.

• Easy to buy. They are easy to buy and can be purchased through your bank or your broker.
• Safety. Because of the guarantees that come with mortgage-backed securities, they are considered very safe investments.

Downside

Perhaps the biggest drawback to mortgage-backed securities is the uncertainty over how long they will continue to pay off. If you buy an MBS when interest rates are high, you might hope to enjoy a great return for the full 30-year term of the security. Unfortunately, if interest rates start to drop, you may be disappointed. Homeowners are very likely to pay off their mortgages when interest rates start falling in order to refinance at a lower rate. So before long, all of the mortgage-buyers in the pool will have refinanced and returned the principal. As a MBS owner, you would receive your principal back, and therefore, would no longer receive interest payments at that high interest rate level. You would need to reinvest your money at a lower rate.

The flip side can be just as frustrating for investors. If you buy an MBS when interest rates are low, if rates start to climb, homeowners are going to hold onto their old mortgages for dear life. Why refinance if you would have to pay a higher rate. As a result, MBS investors would be tied to those low rates for the full term of the security—unable to reinvest their money in the newer, higher-yielding investments.

Mortgage-backed securities have some other minor drawbacks, as well:

• Lower return than stocks. Although mortgage-backed securities typically pay higher rates than other government bonds and AAA corporate bonds, they still fall well below average annual return offered by stocks and high yield corporate bonds. But they are much safer than stocks or junk bonds.
• Long terms. Many mortgage-backed securities are issued with terms of up to 30 years, so you could be stuck with them for a long time. However, you can buy an MBS with a shorter term on the secondary market, and you can unload your MBS on the secondary market whenever you wish.
• High cost of admission. If you want to buy a MBS from Ginnie Mae, the lowest-priced security you can purchase is $25,000. However, Freddie Mac and Fannie Mae securities are available in $1,000 increments.
• Fully taxable. Unlike government bonds, mortgage-backed securities are fully taxable by federal, state, and local governments.

How to Buy Mortgage-backed Securities

You can buy mortgage-backed securities through your bank or broker with roughly the same fee schedule as any other bonds. You would pay between 0.5 and 3 percent, depending on the size of the bond and some other factors.

Ginnie Mae securities come in denominations of $25,000 and higher. For those on a lower budge, you can buy Freddie Mac and Fannie Mae securities for $1,000 or more. You can buy MBS’s with 30-year terms or 15-year terms. In fact, by buying an MBS on the secondary market, you can pick one with nearly any duration you want.

As an MBS owner, you will receive payments every month representing both interest and a small portion of the principal.

Fannie Mae provides a help line for investors at 1-800-237-8627, or (202) 752-6547. The help line is staffed from 9 a.m. to 5:30 p.m., Eastern Time, Monday through Friday.

Biggest Concerns

Mortgage-backed securities are very close to a worry-free investment. They pay relatively high rates and are considered very safe. They are readily available, and are easy to buy and sell on the secondary market.

No question, the biggest concern for MBS owners is the prepayment risk and the extension risk. When rates are dropping, mortgage-backed securities typically get paid off early, so the investor’s high rate of return is cut short early—during a period when it is more difficult to find high-yielding investments. During periods of low rates, you face an extension risk—the very high likelihood that if rates rise, homeowners will stick with their lower-interest mortgages through the full term, leaving you with a low return for years to come. Fortunately you do receive some compensation for that risk in the form of interest rates that average 1 to 2 percent higher than most government bonds.

Timing

Timing is tough to judge with mortgage-backed securities because of the extension and prepayment risks. Do you buy when rates are high when you face the risk of having your mortgages paid off early if rates drop? Do you buy when rates are fairly low, and face the risk of holding low-yielding securities later in a high interest environment? There’s no perfect answer.

The perfect pick for mortgage-backed securities would be to an MBS that represents a pool of older, lower-interest mortgages which the mortgage holders would be unlikely to pay off early. An MBS trades like any other bond—as interest rates rise, the price of older, lower-yielding mortgage-backed securities drops to compensate for the lower yields. So because of the discount, in times of rising interest rates you still get an MBS with a yield that is competitive with the rest of the fixed-income market. But because your MBS represents a pool of earlier mortgages with lower interest rates, your risk of prepayment is sharply reduced.

Otherwise, buying mortgage-backed securities is similar to buying other types of traditional bonds. During periods of low interest rates, you might want to buy a shorter term MBS on the secondary market so that you are not stuck with a low yield for too long. During periods of high interest rates, you can buy an MBS and enjoy the high rates for as long as possible—particularly if you buy one that represents earlier, lower rates with a lower risk of prepayment. Either way, you’re buying into an investment that should provide a better current yield than government bonds and many corporate bonds (which also carry a risk of early redemption).

In times of low interest, if you are choosing between Treasury issues (such as T-bonds and T-notes) and mortgage-backed securities, both could have very long terms, and mortgage securities pay a higher return, so that may be your best bet. During periods of high interest, you might want to invest a little more in Treasury issues because of their non-callable guarantee.

Monitoring Your Mortgage-backed Securities

With billions of dollars in mortgage-backed securities on the market, there is no single source that provides price information on every issue.

However, you should receive periodic statements from the broker who sold you the MBS, giving the current status of the security, including the amount of principal that has been paid and the amount that remains to be paid.

You can find additional information on mortgage-backed securities at www.investinginbonds.com, www.ginniemae.gov, www.fanniemae.com, www.hud.gov, or www.freddiemac.com.

Asset Allocation

The amount of money you allocate toward mortgage-backed securities would depend on your tax situation, your financial situation, your investment goals and your threshold for risk.

Conservative investors concerned with preservation of capital might want to invest 20 to 60 percent of their assets in various fixed-income investments including mortgage-backed securities, T-bonds and corporate bonds under normal economic conditions. You might want to lighten the weighting of fixed income securities in the portfolio during periods of low interest rates, and increase the weighting during periods of high interest.

Aggressive investors looking for long-term growth would probably want to limit their investment in MBS’s, although they are more attractive than many other types of bonds because of their higher returns. An allocation of 5 to 20 percent of assets in fixed income investments such as MBS’s and government and corporate bonds even for aggressive investors would help provide balance and diversification for a portfolio that is heavily weighted in stocks.

Special Considerations

Mortgage-backed securities are commonly assessed based on "average life" rather than a stated maturity date. The average life is the average time that each principal dollar in the pool is expected to be outstanding, based upon preconceived assumptions about prepayment speeds. The average life is always a best estimate, and could fluctuate based on how closely the prepayment speeds of the underlying mortgage loans compare with the initial assumptions.