What are Mortgage Bonds?
Mortgage bonds are a type of bond issued to investors that are secured by mortgages or a pool of mortgages. Typically, these mortgages act as collateral for the bonds issued. Also, the collateral for mortgage bonds is real estate holdings or real property. Therefore, the bondholders receive fixed monthly interest and principal payments. Moreover, if the borrower cannot repay debts, the bondholders can sell the underlying collateral to cover and receive the payments as per the contract terms.
Mortgage bonds are a low-risk investment because real property backs them as security. Because of this safety, these bonds tend to yield lower returns than any other traditional corporate bonds. On the contrary, these corporate bonds are only reliable for the corporation’s promise and ability to pay. Therefore, mortgage bonds can offer protection and return to their investors.
A company borrows Rs.10 lakhs from a bank and keeps its equipment as collateral. The bank becomes the holder of these bonds and has a claim on the equipment. The company has to pay interest and principal back to the bank through periodic coupon payments.
If the company meets all its payment requirements, it can retain ownership of the equipment. On the other hand, if it cannot fully repay the bank, the bank can sell the equipment to recover the loan amount.
What is the Purpose of Issuance of Mortgage Bonds?
The government and mortgage companies issue these bonds because –
- Mortgage bonds protect lenders and allow borrowers to borrow large amounts at lower costs.
- These bonds can be securitised into a mortgage-backed security. They can be sold to investors in a secondary market that allows bondholders to transfer risks.
- It also helps to bring in more liquidity in the capital market.
How Does Mortgage Bonds Work?
Mortgage bonds are a pool of mortgages where a real estate or real property backs them. Whenever someone buys a home and finances it by keeping it as a mortgage, the lender gets the ownership of the mortgage until the loan is cleared. Usually, the lenders are banks or mortgage companies that provide loans on real estate assets. They sell the mortgage in the secondary market to an entity like an investment bank or government sponsored enterprise. These sold mortgages with a pool of other loans become mortgage bonds.
The investment bank transfers this pool of loans to a Special Purpose Entity (SPE). The SPEs issue bonds on these loans secured by a mortgage. The cash flow from loans is passed on as interest and principal payments to bondholders. If payment default happens, the bondholders can foreclose the collateral to receive their payment.
Let us assume that 20 people borrowed a loan of Rs.2.5 lakh each at 7% by offering their house as collateral to the bank. The total mortgage loan the bank will book is Rs.50 lakhs. Now the bank can sell this pool of mortgages to an investment bank. It will use the sale proceeds to make new loans.
The investment bank will group this pool of mortgages into 500 mortgage bonds of Rs.10,000 each with 6% interest. The bank will pass on the interest and principal payment to the investment bank after keeping its fee (say 0.5% of the loan amount). Also, the investment bank will keep its spread of 0.5% of the loan amount and pass it on to the investor. So every year, each investor will receive Rs. 600 (6% *10,000) in the interest payment plus the principal amount. At the same time, the bank and investment bank will get Rs.25,000 each in the mortgage pool.
Advantages and Limitations of Mortgage Bonds
The following are the advantages of mortgage bonds –
- These bonds are a relatively low-risk investment option as assets back them.
- It offers asset diversification to its investors as it has a low correlation with other asset classes.
- In case of default, this bond is a good investment option as the bondholder has the right to sell the collateral to compensate for its loss.
- Usually, the monthly payments of these bonds comprise both interest and principal payments which mitigate the risk to a large extent. Usually, for other bonds, the principal amount is paid upon maturity.
- Moreover, these bonds can be securitised and sold to investors, providing more liquidity in the capital market and allowing the transfer of risk.
The following are the limitations of mortgage bonds –
- The mortgage bonds offer lower yields than other traditional corporate bonds because security backs them.
- Sometimes, the lender also has the risk of losing the collateral if the borrower fails to make the payments. Although the lender has the ownership of the collateral, it is not always that the lender can sell the collateral for an amount that can fully cover the loss. It can also be sold at a lower price than its fair market value price.