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 o0f 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 "certificate holders."
Most mortgage-backed securities are issued by three primary agencies: the Government National Mortgage Association, the Federal Home Loan Mortgage Association, and the Federal National Mortgage Association. 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:
- 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.
- Real estate mortgage investments conduits (REMICs) are similar to collateralized mortgage obligations with a twist. While CMOs separate mortgage securities into maturity classes, REMICs also separate them into risk classes. A REMIC might 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.
- Mortgage-backed securities might be stripped of their interest coupons and sold as zero-coupon bonds. Rather than make regular monthly interest and principal payments, they 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.
