How Are Mortgage-Backed Securities Different from Other Bonds?

A mortgage-backed security (MBS) pays you a share of homeowners' monthly mortgage payments, so you get interest and part of your principal back every month. A Treasury note or a typical corporate bond pays interest every six months and returns all of the principal at maturity. Because homeowners can pay off their loans early, often by refinancing when rates drop, you cannot know when an MBS will return your money. MBS may offer higher yields than Treasuries, but estimates depend on the purchase price and assumed prepayments.

For how the securities are built, start with what a mortgage-backed security (MBS) is. This page compares them with other bonds and covers their advantages and how they are hedged.

MBS vs. Treasuries and corporate bonds

Treasury notes run 2, 3, 5, 7, or 10 years and pay a fixed rate every six months until they mature, according to TreasuryDirect. With a corporate bond, the SEC notes, you lend to a company that promises interest during the bond's life and the face value at maturity; if the company fails to pay, you take the loss.

An agency MBS works differently. The trust holding the loans passes each month's payments from homeowners to investors, minus servicing and guarantee fees, which is why its coupon (stated interest rate) is slightly lower than the rate on the loans inside it. The guarantor covers missed payments. Ginnie Mae's guarantee has the full faith and credit of the U.S. government. Fannie Mae and Freddie Mac guarantees are obligations of those companies without that federal guarantee, so their ability to pay still matters. Private-label MBS, issued without an agency guarantee, add credit risk on top of that.

A worked example of the cash flows

Say you put $10,000 into each of two securities.

• Treasury note at 4%: you receive $200 every six months ($10,000 x 4% / 2) and $10,000 back at maturity.
• MBS with a 5% coupon, backed by 30-year loans (assume they amortize at 5%): in month one you receive $41.67 of interest ($10,000 x 5% / 12) plus about $12.01 of scheduled principal, the amount a 30-year amortizing payment of $53.68 retires in its first month. If homeowners holding 1% of the remaining balance pay off their loans that month, you also get about $100 back. Next month's interest is figured on the smaller balance.

The Treasury's cash flow is fixed. The MBS cash flow depends on what the homeowners in the pool decide.

Prepayment risk and extension risk

Most U.S. homeowners can pay off their mortgage at any time, and they do so more as rates fall. That option belongs to the borrower, and MBS investors are on the other side of it.

• Prepayment risk (rates fall): homeowners refinance, and your principal returns early. The SEC notes this tends to happen exactly when reinvesting the money pays less. A falling-rate market also lifts MBS prices less than Treasury prices, because buyers expect the higher-rate loans to be paid off.
• Extension risk (rates rise): refinancing slows, payoffs drop, and you keep earning a below-market rate for longer. The Federal Reserve Bank of New York explains that MBS prices then fall faster than prices of a comparable Treasury, a pattern called negative convexity.

A callable corporate bond also carries the risk of early repayment. The SEC describes call risk as an issuer retiring a bond early after rates fall, much like a homeowner refinancing. Treasury notes have no such feature.

If you own a home, your own refinancing decision is part of this. When you refinance a mortgage, the old loan is paid off in full, and that payoff flows to whoever holds the MBS it was pooled into.

Why MBS may offer a yield spread over Treasuries

A yield spread is the difference between an MBS yield and a Treasury yield. Researchers at the Federal Reserve Bank of New York link higher agency MBS yields to compensation for the borrower's prepayment option. The same research found that spreads jump during market stress, such as the fall of 2008, so the spread is not fixed.

An MBS yield estimate depends on the purchase price and assumed prepayments; its coupon alone does not establish your return. Fannie Mae warns that if you buy above face value, faster-than-expected prepayments can lower your yield and rapid prepayments can cause a loss.

What advantages do MBS offer?

For an investor who accepts the timing risk, agency MBS offer three things:

1. Monthly cash. Interest and some principal arrive every month instead of twice a year, giving you money to reinvest or spend before maturity, though the amount varies.
2. Potentially higher yields than Treasuries. Compare estimates using the purchase price and prepayment assumptions, rather than the coupon alone.
3. A large, liquid market. Most agency MBS trade in the to-be-announced (TBA) market, a forward market the Federal Reserve Bank of New York credits with raising MBS liquidity and lowering mortgage rates for borrowers.

If you need a known amount on a known date, a Treasury note fits better. Funds that hold many MBS spread out the prepayment pattern; see whether an MBS fund is a better fit than individual securities.

How are mortgage-backed securities hedged?

A hedge is a second position that gains when the first one loses. MBS are usually hedged with derivatives, contracts whose value depends on another price or rate. Lenders and large investors hedge for different reasons.

Lenders: TBA forward sales

A lender that gives you a rate lock, typically for 30 to 90 days, loses money if rates rise before it sells the loan. To cover that gap, the lender sells MBS forward in the TBA market, agreeing today on the price for securities it will deliver at a set future date. Only six terms are fixed at the trade: issuer, maturity, coupon, price, amount, and settlement date. The specific loan pools are named two business days before settlement. Lenders can also hedge with Treasury futures (contracts to buy or sell Treasury securities at a future date), but the New York Fed researchers call TBAs the better hedge because Treasury futures prices can move differently from MBS prices.

Investors: interest rate swaps and Treasuries

Investors that hedge actively include mortgage REITs (real estate investment trusts that own mortgages or MBS), mortgage servicers, and Fannie Mae and Freddie Mac. They manage duration, the measure of how much a bond's price moves when rates change. Because MBS duration grows when rates rise, these investors sell Treasury notes or bonds or pay fixed in an interest rate swap (an agreement to swap fixed-rate payments for floating-rate payments). When rates fall, they do the reverse. The Dallas Fed reports that mortgage REITs mainly use interest rate swaps to manage the rate risk of agency MBS they finance with short-term borrowing. The New York Fed lists banks, foreign sovereign wealth funds, the Federal Reserve, and mutual funds that track an MBS index among holders that hedge rarely or not at all.

For the other ways to earn income from home loans, see how you can earn income from other people's mortgages and examples of mortgage-backed securities.