A type of bond secured by mortgages that is typically real estate or other real assets
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What is a Mortgage Bond?
A mortgage bond is a type of bond secured by mortgages that is typically real estate or other real assets. The assets are also known as the collateral of the bonds.
Holders of mortgage bonds can make claims on the collateral. If borrowers cannot repay their debts, bondholders can sell the underlying assets to cover the payments that they should receive according to the contract terms.
Summary
- A mortgage bond is a type of bond secured by mortgages, such as real estate, equipment, or other real assets.
- Mortgage bonds protect lenders and allow borrowers to borrow larger amounts at lower costs.
- The bonds can be securitized into a mortgage-backed security and sold to investors in the secondary market, which allows the bondholders to transfer risks.
Understanding Mortgage Bonds
Mortgage bonds are secured by a valuable real asset or a set of assets, which protect bondholders. If the borrower defaults, the mortgage bondholders are entitled to sell the collateral assets to get the principal paid.
When and how the bondholders can sell the assets, as well as how the money from the sale is distributed, are determined by the contract terms. As a result of a lower level of risk, mortgage bonds usually carry lower interest rates than typical corporate bonds that are not secured by real assets.
For example, a company borrowed $1 million from a bank and put its equipment up as collateral. The bank is the holder of the mortgage bond and owns a claim on the company’s equipment. The company pays interest and the principal back to the bank through periodic coupon payments.
If the company meets all the payments, it can retain its ownership of the equipment. If it cannot fully repay the bank, the bank is entitled to sell the equipment to recover the money lent.
Pros and Cons of Mortgage Bonds
Mortgage bonds provide several advantages to both borrowers and lenders. Holding a claim on real assets, the lenders of such bonds bear lower potential losses in the case of default. Mortgage bonds also allow less creditworthy borrowers to access larger amounts of capital at lower borrowing costs.
Mortgage bonds can be securitized into financial derivatives and sold to investors, which provides more liquidity in the capital market and allows the transfer of risks.
One of the drawbacks of mortgage bonds is the risk of losing the collateral if the borrowers fail to make the payments. Although the lender obtains ownership of the underlying collateral, it is not always the case that the lender can sell the collateral for an amount that can fully cover the loss. Collaterals are usually sold at prices lower than the fair market values of comparable assets.
Mortgage Bonds and Mortgage-Backed Securities
Lenders of mortgage bonds and loans, such as banks, do not usually retain the ownership of mortgages. Instead, they securitize the mortgages into financial products that can be sold in the secondary market. Such a type of financial product is known as a mortgage-backed security (MBS).
A special purpose vehicle (SPV) – the originator of the MBS – gathers mortgages from a bank into a pool and sells small packages of the mortgages to investors. The originator gathers interest payments from the mortgage borrowers and then distributes the payments to the MBS investors. Hence, the default risk is transferred to the MBS investors.
Subprime Mortgages
Despite providing liquidity and investment opportunities in the capital market, MBS investments can lead to a moral hazard. Banks, as the lenders of mortgage bonds, are expected to carefully evaluate the credit risks of the bonds and only lend to borrowers that meet the standards.
However, as banks can transfer the credit risks to investors through MBS, they tend to lower their standards and lend to borrowers with low credit ratings. Such a moral hazard may lead to an increasing number of subprime mortgages. The 2008 Global Financial Crisis is attributable to the overabundance of subprime mortgages and widespread defaults on these mortgages.
Additional Resources
CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.
To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:
FAQs
A mortgage bond, simply put, is a type of bond secured by mortgages. These financial instruments typically hold real estate as collateral. Issuers sell mortgage bonds to real estate investors, who then receive regular interest payments on the underlying mortgage loans until that debt is paid off.
What happens if a mortgage bond fails? ›
Mortgage bonds offer the investor protection because the principal is secured by a valuable asset. In the event of default, mortgage bondholders could sell off the underlying property to compensate for the default and secure payment of income.
How frequently do mortgage pass through bonds make payments? ›
As the name suggests, the issuer or servicer of mortgage pass-through securities collects monthly payments from the mortgagees whose loans are in a given pool and “passes through” the cash flow to investors in monthly payments that represent both interest and repayment of principal.
What are the disadvantages of mortgage bonds? ›
Some main disadvantages of mortgage bonds are the risk of losing collateral and receiving lower yields than corporate bonds.
How do people make money on mortgage bonds? ›
As with any loan, interest payments are made and then principal is paid back at maturity. However, with a mortgage-backed security, interest payments to investors come from the thousands of mortgages that underlie the bond — specifically, the repayments in interest and principal the mortgage-holders make each month.
What is an example of a mortgage bond? ›
For example, a company borrowed $1 million from a bank and put its equipment up as collateral. The bank is the holder of the mortgage bond and owns a claim on the company's equipment. The company pays interest and the principal back to the bank through periodic coupon payments.
How to short mortgage bonds? ›
Going Short
To do so would require locating an existing holder of that bond and then borrowing it from them to sell it in the market. The borrowing involved may include the use of leverage, and if the price of the bond increases instead of falling, the investor has the potential for large losses.
How often do mortgage bonds pay interest? ›
Mortgage-backed securities offer competitive returns, but with less predictability of interest and principal payments than other types of fixed income securities. Interest income is paid monthly on the outstanding principal value.
Is a mortgage bond a current liability? ›
Bonds, mortgages and loans that are payable over a term exceeding one year would be fixed liabilities or long-term liabilities. However, the payments due on the long-term loans in the current fiscal year could be considered current liabilities if the amounts were material.
What happens to mortgage bonds when interest rates rise? ›
Interest rates and bond prices have an inverse relationship. When interest rates go up, the prices of bonds go down, and when interest rates go down, the prices of bonds go up.
The mortgage yield, or cash flow yield, of a mortgage-backed bond is the monthly compounded discount rate at which net present value of all future cash flows from the bond will be equal to the present price of the bond.
What happens to mortgage interest rates when bonds go up? ›
The Relationship Between Bonds And Mortgage Rates
Bond prices and mortgage interest rates have an inverse relationship with one another. That means that when bonds are more expensive, mortgage rates are lower. The reverse is also true – when bonds are less expensive, mortgage interest rates are higher.
Are mortgage bonds secured or unsecured debt? ›
Types of secured bonds include collateral trust bonds, mortgage bonds and equipment trust certificates.
Are mortgage bonds fixed income? ›
Asset-backed securities (ABS) and mortgage-backed securities (MBS) are two of the most important types of asset classes within the fixed-income sector. MBS are created from the pooling of mortgages that are sold to interested investors, whereas ABS is created from the pooling of non-mortgage assets.
Are mortgage bonds callable? ›
The most important callable bond is the fixed rate amortizing mortgage; calling a mortgage means prepaying your remaining balance.
Why do people buy mortgage bonds? ›
Attractive yields
Mortgage-backed securities typically offer yields that are higher than government bonds. Securities with higher coupons offer the potential for greater returns but carry increased credit and prepayment risk, meaning the realized yield could be lower than initially expected.
Is a bond better than a loan? ›
A loan obtains funding from a lender, like a bank or specific organizations. In contrast, bonds obtain money from the public when companies sell them. In either case, the corporation typically has to repay the borrowed money at a prearranged interest rate. To start, bonds usually have a lower interest rate than loans.
How to understand bonds for dummies? ›
Bonds are issued by governments and corporations when they want to raise money. By buying a bond, you're giving the issuer a loan, and they agree to pay you back the face value of the loan on a specific date, and to pay you periodic interest payments along the way, usually twice a year.
