Benefits of Investing in Mortgage-Backed Securities

Looking to diversify your portfolio? Mortgage-backed securities, also known as mortgage-related security or a mortgage pass-through, can be a great way to do so. A mortgage-backed security (MBS) is a bundle of home loans put together from a single lender, such as a bank. Banks look to investors to finance these home loans, and in turn pay periodic payments to investors. The process is quite similar to bond investments.

So, what makes mortgage-backed securities a stellar option for investors? Read on to find out!

MBS offers strong returns

As an investment opportunity, mortgage-backed securities offer a strong rate of return. Each month, investors receive a portion of principal and interest payments made by borrowers on the home loans in their bundle. This process continues until the mortgage is paid in full. Reports show that, over the past 10 years, mortgage-backed securities have returned at a rate 2.17% higher than treasury bills. In addition, mortgage-backed securities offer fairly low volatility.

MBS provide a regular cash flow

When you invest in a mortgage-backed security, you will receive a payout from that security every single month. Although the value of that payout may fluctuate, you will continue to receive income from your mortgage-backed security as long as it still contains active mortgages.

MBS have amazing liquidity

When it comes to investments, liquidity is a significant consideration. Liquidity refers to the capabilities of an investor to convert an asset, like an investment, into cash. If an investment is easy to sell, it is considered to have high liquidity. If the market for an asset is rather stagnant and it’s difficult to transfer, it’s considered to have low liquidity. Most investors look for assets that are easy to buy, sell, and trade.

The mortgage-backed security market offers astounding liquidity. In 2020, the industry boasted $7.8 trillion in assets and an average trading volume of $332 billion. That means buying, selling, and trading mortgage-backed securities is quick and relatively simple. This can be especially attractive in the case of an increase in interest rates, if a lender hasn’t offered a lock desk.

Backed MBS have relatively low credit risk

For mortgage-backed securities that are backed by federal agencies or government sponsored entities, credit risk is relatively low. That’s because credit risk is directly related to the number of borrowers who default on their loans.

The following mortgage-backed securities are guaranteed by three different government-sponsored enterprises:

• Government National Mortgage Association (GNMA): While Ginnie Mae does not purchase or sell mortgages, it does guarantee principal and interest payments. They are backed by the U.S. government.

• Federal National Mortgage Association (FNMA): Fannie Mae purchases, packages, and sells mortgage-backed securities to investors. Rather than being backed by the U.S. government, they back themselves.

• Federal Home Loan Mortgage Corporation (FHLMC): Freddie Mac purchases, packages, and resells mortgage-backed securities to investors. Just like Fannie Mae, these securities are guaranteed by Freddie Mac itself.

As a general rule, credit risk increases as federal and government backing decreases. However, the fact that multiple loans are pooled together helps to substantially minimize the risk of a single lender defaulting.

MBS offer geographic diversity

Mortgage-backed securities are not grouped by location; a single mortgage pool can include mortgages from a number of different places across the US. This gives them great strength against fluctuations in specific housing markets or areas. The pool of mortgages can help disperse the effect of a market crash or fluctuation in a specific area of the United States.

Reduce prepayment risk with CMOs

An inherent risk when investing in mortgage-backed security is the risk of prepayment. In pass-through mortgage-backed securities, the prepayment, or early payment, of a mortgage can dramatically decrease the payout of your mortgage pool. This can happen when a borrower pays off a loan early, whether from a greater-than-expected influx of cash or from a refinancing.

Collateralized mortgage obligations are another type of mortgage-backed securities that are designed to reduce the risk of prepayment. These types of mortgage-backed securities create a chain of several different mortgage pools, known as tranches, and pass finances from one tranche to another to disperse the effect of prepayment across a number of investors, lessening the blow.

This article does not necessarily reflect the opinions of the editors or management of EconoTimes