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The Short Answer

Homing In on Mortgage-Bond Types

We explain the difference between residential and commercial issues, and agency and nonagency issues.

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Question: I know there are several different types of mortgage bonds. Can you explain what they are?

Answer: Like most bonds, a mortgage-backed bond is a type of debt security in which the bondholder essentially finances a loan in exchange for periodic interest payments and, ultimately, a return of principal. But unlike, say, a government bond, in which the entire loan amount goes to a single borrower--such as the federal, state, or local government--these bonds are backed by baskets of loans, each made to purchase or build property, that have been packaged into a tradable security. These are known as mortgage-backed securities, or MBSs. In their simplest form, the mortgage pass-through, as the borrowers pay off principal and interest, these cash flows are passed on to the bondholder.

MBSs are grouped according to the type of mortgages they represent as well as the nature of the issuer, which also determines whether interest and repayment of principal is guaranteed. In addition to the relatively straightforward pass-through structure, mortgage cash flows also can be sliced and diced in various ways, with, for example, one type of security only receiving principal payments and another only receiving interest payments. MBSs, generally, are classified as either residential or commercial in nature and as either agency or nonagency, depending on the issuer--an important distinction we'll discuss in a moment.

Types of Mortgages
MBSs make up about one third of the Barclays U.S. Aggregate Bond Index, the most popular benchmark for the investment-grade U.S. bond market. Most mortgage-backed securities are backed by pools of residential mortgages. As the name implies, this includes mortgages on people's homes, such as the one you may pay monthly on your house or condo.

Commercial mortgage-backed securities, on the other hand, are made up of loans used for the purchase or construction of commercial properties. These can include retail, office, or industrial properties, as well as apartment buildings and hotels.

Most residential mortgage-backed securities are backed by a government agency such as the Government National Mortgage Association (GNMA, also known as Ginnie Mae) or a government-sponsored enterprise such as the Federal National Mortgage Association (Fannie Mae) or the Federal Home Loan Mortgage Corporation (Freddie Mac). MBSs issued by Ginnie Mae are backed by the full faith and credit of the U.S. government as a guarantee that investors will receive their bond payments on time. Those issued by Fannie Mae or Freddie Mac technically carry lesser guarantees, but since both government-sponsored enterprises were placed into conservatorship under the Federal Housing Finance Agency during the 2008 financial crisis, it is assumed that the credit quality of their mortgage-backed securities is nearly as high as those issued by Ginnie Mae. (Not that Ginnie Mae bonds' immunity to credit risk makes them immune to other forms of risk, as you can read more about here.)

MBSs not backed by Ginnie Mae, Fannie Mae, or Freddie Mac are sometimes referred to as "private-label" mortgage securities. These are loans that generally don't qualify for government guarantees and, therefore, are considered to be of lower quality. If a borrower defaults on his or her mortgage, the bondholder is exposed to loss. However, nonagency MBSs offer higher payouts than agency MBSs to compensate investors for this added risk. 

Of course, the credit-worthiness of nonagency MBSs played a major role in causing the financial crisis. At the time, there were far more private-label MBSs being issued than there are today. As housing prices plummeted and more and more residential borrowers defaulted on their mortgages, the value of many of those residential MBSs fell sharply. Today, most of the residential nonagency MBSs on the market are rated as below investment-grade. Funds that buy them typically get them for heavily discounted prices and are betting that they can identify those that either will pay off or deliver enough value despite a default to generate strong total returns.

One of today's best-known bond-fund managers, Jeffrey Gundlach, relies heavily on nonagency mortgages in running his  DoubleLine Total Return Bond (DBLTX) fund, though not to the extent that he did previously. As of June 2014, the fund held 28% of assets in nonagency mortgage bonds, down from about 50% four years earlier.  

Other MBS Risk Factors
Like other bonds, mortgage-backed bonds carry interest-rate risk, meaning their value typically declines as rates rise, while nonagency mortgages also carry credit risk.

A third risk to consider when investing in the residential mortgage market also has to do with interest rates, and that is prepayment risk. Because a borrower can refinance a mortgage at any time without a penalty--resulting in a return of principal to the bondholder termed a "prepayment"--there is considerable uncertainty about the timing of cash flows for mortgage bondholders. When mortgage rates fall, prepayments typically accelerate, returning principal to investors to reinvest at a lower rate--exactly the opposite of what you'd want in such an environment. Mortgages pay additional income to compensate for this risk, but active mortgage managers spend a lot of time analyzing how well they're getting paid for this risk.

In a sense, mortgage-backed bonds are vulnerable to interest-rate risk in two directions. If rates rise, the value of the bond may decrease, whereas if they fall, the bond may be vulnerable to prepayment risk. That's one reason why investing in mortgage-backed bonds is so tricky.

While most MBSs fall into one of the categories already discussed, there are other types as well. For example, there are MBSs whose underlying holdings consist of adjustable-rate mortgages (ARMs) or collateralized mortgage obligations (CMOs), a complex type of mortgage-backed security that's created by slicing and dicing a mortgage pool's cash flows. CMOs have different levels of exposure to refinancing risk and credit risk (for nonagency CMOs) depending on how they are structured.

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Adam Zoll does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.