Smart Bond Investing—Types of Bonds

Mortgage-Backed Securities

Mortgage-backed securities, called MBSs, are bonds secured by home and other real estate loans. They are created when a number of these loans, usually with similar characteristics, are pooled together. For instance, a bank offering home mortgages might round up $10 million worth of such mortgages. That pool is then sold to a federal government agency like Ginnie Mae or a government-sponsored enterprise (GSE) such as Fannie Mae or Freddie Mac, or to a securities firm to be used as the collateral for the new MBS.

The majority of MBSs are issued or guaranteed by an agency of the U.S. government such as Ginnie Mae, or by government-sponsored enterprises (GSEs), including Fannie Mae and Freddie Mac. Mortgage-backed securities carry the guarantee of the issuing organization to pay interest and principal payments on their mortgage-backed securities. While Ginnie Mae's guarantee is backed by the "full faith and credit" of the U.S. government, those issued by GSEs are not.

Varied Monthly Payments

There's one more thing about those portions you've been getting—they are not the same each month. For this reason, investors who draw comfort from a dependable and consistent semiannual payment may find the unpredictability of mortgage-backed securities unsettling. Unlike a traditional fixed-income bond, most mortgage-backed securities bondholders receive monthly—not semiannual—interest payments. There's a good reason for this. Homeowners (whose mortgages make up the underlying collateral for the MBS) pay their mortgages monthly, not twice a year. These mortgage payments are what ultimately find their way to MBS investors.

Types of Mortgage-Backed Securities

Pass-Throughs

The most basic mortgage securities are known as pass-throughs. They are a mechanism—in the form of a trust—through which mortgage payments are collected and distributed (or passed through) to investors. The majority of pass-throughs have stated maturities of 30 years, 15 years and five years. While most are backed by fixed-rate mortgage loans, adjustable-rate mortgage loans (ARMs) and other loan mixtures are also pooled to create the securities. Because these securities "pass through" the principal payments received, the average life is much less than the stated maturity life, and varies depending upon the paydown experience of the pool of mortgages underlying the bond.

Collateralized Mortgage Obligations (CMOs)

Collateralized mortgage obligations, CMOs for short, are a complex type of pass-through security. Instead of passing along interest and principal cash flow to an investor from a generally like-featured pool of assets (for example, 30-year fixed mortgages at 5.5 percent, which happens in traditional pass-through securities), CMOs are made up of many pools of securities. In the CMO world, these pools are referred to as tranches, or slices. There could be scores of tranches, and each one operates according to its own set of rules by which interest and principal gets distributed. If you are going to invest in CMOs—an arena generally reserved for sophisticated investors—be prepared to do a lot of homework and spend considerable time researching the type of CMO you are considering (there are dozens of different types), and the rules governing its income stream.

Many bond funds invest in CMOs on behalf of individual investors. To find out whether any of your funds invests in CMOs, and if so, how much, check your fund's prospectus or SAI under the headings "Investment Objectives" or "Investment Policies."

Mortgage-Backed Securities Risk Report Card   Credit and default risk are real for MBSs issued by GSEs: The federal government is under no legal obligation to save a GSE from default.   Prepayment risk that acts much like call risk: You get your principal back sooner than the stated maturity, but the reinvestment opportunities are limited due to the inconsistent prepayment rates, which are driven by real estate mortgage interest rates and refinancing trends; population, geographic mobility and employment opportunities; and social and economic factors that are difficult to model.   Extension risk: The opposite of prepayment risk—the risk that interest rates will go up, lengthening the estimated maturity (but not the stated maturity) of your MBS and creating more holding-period risk.   Interest rate risk: If interest rates rise, the value of a mortgage-backed security on the secondary market will likely fall.