Before You Invest...
The story of the lowly home mortgage that became a popular investment security is the
financial world's equivalent of the ugly duckling who was transformed into a swan.
The transformation began in the late 1960s when Congress created the Government National
Mortgage Association (Ginnie Mae) to increase the flow of capital available to home buyers. To
do this, mortgage lenders pooled individual mortgage loans to create securities guaranteed by
Ginnie Mae. The interest and principal generated by the underlying mortgages were passed
through to investors who purchased certificates, representing the pool of mortgages with
Ginnie Mae guaranteeing timely payment of both interest and principal even if the homeowner
defaulted. The original lender could use the proceeds of the sale of mortgage-backed securities
to make new mortgage loans.
During the next two decades, two other government-sponsored organizations—the Federal
National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Association (Freddie Mac)—joined Ginnie Mae as important "middlemen" in the creation and sale of mortgage-backed securities.
Today, over half of all home mortgages originated each year are ultimately sold to investors in
the form of pass-through securities. Virtually all types of mortgages have been pooled into such securities, e.g., 30- and 15-year fixed rate mortgages, adjustable rate mortgages
(ARMs), graduated payment, etc., but a much higher percentage of fixed rate mortgages than ARMs are packaged into securities.
Because these instruments are complex and issued in large denominations, the mortgage-backed securities market
tends to be dominated by institutional investors. However, individual investors may participate in this market through fixed income
mutual funds that invest in mortgage-backed securities.
| GNMA Pool Organization |
- Mortgage lender gives commitment to the home buyer.
- Mortgage lender obtains guarantee from GNMA.
- Buyer settles on house; mortgage is obtained.
- Lender pools similar mortgages and delivers to securities dealer but retains responsibility for servicing.
- Securities dealer sells mortgage pools, in whole or in part, to investors and advises GNMA of new owners.
|
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- After the pool is originated, the lender collects monthly payments of principal and interest from the home buyer by the 30th of each month and forwards them to GNMA.
- GNMA disburses payments to investors by the 15th of the following month whether or not payment has been received from the home buyer.
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Yields on Mortgage-Backed Securities
One of the primary advantages of investing in mortgage-backed securities is that the yield
tends to be higher than on U.S. Treasury notes and bonds with comparable maturities, even
though there is little or no additional credit risk. The graph below shows that the yield of a
GNMA certificate, for example, has been at least 125 basis points or one and one-quarter
percentage points higher than that of a 10-year Treasury note in recent years. (Mortgage rates
are typically set with reference to the 10-year Treasury.)
On newly issued fixed rate securities, yields will reflect current mortgage rates minus fees
charged for servicing and guarantees, leading to a yield about one-half a percentage point
below yields on the pooled mortgages. On ARM securities, yields should closely track
short-term interest rates because the mortgage rate paid by the homeowner is periodically
adjusted, or reset, usually once a year, based on one of several commonly used indices. In
general, the yield on ARM securities is 1.5 to 2.0 percentage points over a specified
benchmark, such as the yield on a one-year Treasury bill. But if short-term interest rates rise
sharply, ARM yields may not keep pace since most ARMs limit the amount the rate can rise
in any one year and over the life of the loan.
Risks of Mortgage-Backed Securities
The yield advantage of mortgage-backed securities may sound like a "free lunch," but it's not.
The higher yield compensates the investor for the risks that are different from those typical of
other high-quality fixed income securities.
Market Risk.
Mortgage-backed securities act essentially like other high-quality bonds of similar maturity.
They fluctuate in value as interest rates change: falling rates generally result in higher prices,
and rising rates generally lead to lower prices. As with all bond investments, there is the
potential to lose money when investing in these securities.
Market risk is generally higher with longer-term securities than with shorter-term issues. As
the table shows, the potential change of a bond's value increases with longer maturities, so
longer-term bonds are usually more volatile than shorter-term bonds. The example shows how
values of bonds with various maturities change when interest rates rise or fall by one
percentage point. The bonds are assumed to be of equal quality, to have 6% coupons, and to
have $1,000 par values.
| Bond Maturity in Years |
Rates fall 1%, and the bond's value rises to: |
Rates rise 1%, and the bond's value drops to: |
| 1 |
$1,009.63 |
$990.50 |
| 3 |
$1,027.50 |
$973.36 |
| 5 |
$1,043.76 |
$958.40 |
| 10 |
$1,077.90 |
$928.90 |
| 30 |
$1,154.50 |
$875.30 |
The chart is for illustrative purposes only and does not represent the performance of any T. Rowe Price investment.
The example shows value changes apart from fluctuations caused by other market conditions and factors.
For reasons discussed later, mortgage-backed securities may lag other high-quality bonds when interest rates fall.
Credit Risk.
All bond investors should be aware of the possibility that the issuer may not be able to make
timely payment of interest and principal to the bondholder. As mentioned, there is little or no
additional credit risk in mortgage-backed investments compared with Treasuries because of
the federal government's relationship to the agencies that issue mortgage-backed securities.
Because Ginnie Mae is part of the Department of Housing and Urban Development, its
securities have the same "full faith and credit" backing that the U.S. government gives to
Treasuries. The mortgages in Ginnie Mae pools are either insured by the Federal Housing
Administration (FHA) or guaranteed by the Veteran's Administration (VA).
Fannie Mae and Freddie Mac are privately owned, government-chartered corporations. Fannie
Mae, which also deals in FHA and VA mortgages, guarantees timely interest and principal
payments on all its mortgage-backed securities. Freddie Mac guarantees timely interest
payments on all its securities and timely principal payments on certain types. While both
corporations maintain close ties to the federal government, their guarantees are not backed by
the full faith and credit of the U.S. government.
Maturity and Prepayment Risk.
Although a mortgage-backed security may represent a pool of 30-year mortgages, its actual
maturity is likely to be substantially shorter if homeowners choose to pay off their loans
prematurely to buy a new home or to refinance at a lower interest rate when rates are falling.
This maturity uncertainty exists because of prepayment risk.
Prepayments, which will typically increase in a declining interest rate environment, affect the
investor in several ways. First, they result in unpredictable cash flows over the life of the
security, which may adversely affect the security's yield. Second, they may limit the potential
price gain of the mortgage-backed security when rates are falling. Third, they may cause a
capital loss if the security was originally purchased at a price above its face (par) value.
As you can see by the graph, prepayment activity was fairly low for most of 1997 but spiked
higher late in the year as interest rates tumbled in response to the Asian financial crisis.
Prepayment activity remained strong throughout 1998 as rates continued to fall. In 1999, rates
climbed steadily, and prepayment activity spiked higher again at mid-year when the Federal
Reserve started raising short-term rates. For the rest of 1999, prepayment activity tapered off.
The mortgage market has become increasingly sophisticated in predicting prepayment risk, so
the investor can anticipate how mortgage-backed securities may behave under different
interest rate scenarios. A higher level of maturity certainty may be achieved through careful
coupon selection and by using derivative securities such as collateralized mortgage obligations
(CMOs), which divide monthly interest and principal payments from pools of mortgages to
create new securities with short-, medium-, and long-term maturities. However, certain "exotic"
CMO structures may be subject to greater risk than other mortgage-backed securities and
could be more volatile.
The Mutual Fund Solution
While mortgage-backed securities represented a conceptual breakthrough for mortgage
finance, investing in them directly is not appealing to most individuals for several reasons: high
minimums ($25,000 for Ginnie Maes); the need to reinvest monthly interest and principal
payments; the complexities of tracking these payments for tax purposes; and the need to
understand each issue's probable prepayment profile.
Mutual funds, with their low minimums, high liquidity, convenient recordkeeping, and
professional management, have made these securities practical and popular investments for
individuals. Fund managers can pursue strategies that may cushion potential risks while
providing investors with a diversified portfolio of mortgages with higher yields than Treasury
securities and similar credit quality.
Before You Invest...
Sometimes investors confuse the guarantees regarding timely interest and principal payments
on the underlying mortgages with fund share prices. Please remember that the prices of funds
that invest in mortgage-backed securities are not guaranteed by the full faith and credit of the
government even if some of the securities in the portfolio are backed by the government. The
prices of government-backed mortgage securities and the funds that invest in them will
fluctuate. In addition, the fund's yield is not equivalent to the total return, which takes into
account price changes during a given period as well as reinvested monthly income payments.
If you seek higher income than is provided by Treasury securities of comparable maturity and
can accept the risks of investing in mortgage-backed securities, you may find such investments worth considering.
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