What it means
There are two main meanings. In one, a company issues a bond secured by a mortgage on its own property, such as a utility pledging its power stations, so that bondholders have a claim on the asset if the company cannot pay.
In the other, a financial institution gathers many home loans into a pool and sells bonds whose payments come from the borrowers' monthly mortgage payments. The pooled version is often called a mortgage-backed security.
Each month, borrowers pay interest and principal, and those payments flow through to bondholders after servicing costs are deducted. Because the cash flow comes from thousands of ordinary households, the risk is spread rather than concentrated in a single borrower.
Investors favour these bonds for steady income and typically better yields than government bonds. The extra yield pays for risks such as prepayment, which is when borrowers repay early and the investor must reinvest at lower rates, and credit risk, which is when borrowers default.
Rating agencies assess these risks and assign grades. A key nuance is that not all pools are alike.
Bonds backed by loans guaranteed by a government agency carry little credit risk, whereas bonds backed by weaker loans carry much more. The financial crisis of 2007 to 2009 showed what happens when risky loans are packaged and sold as if they were safe.
For companies, issuing a secured mortgage bond usually lowers borrowing costs, because the lender has a claim on a specific asset. The company must keep the property insured and maintained, and cannot sell it freely while the bond is outstanding.
Pricing follows the usual bond logic. When market interest rates rise, the price of an existing mortgage bond falls, and when rates fall, the price rises, although prepayments complicate the picture.
Investors therefore look at both the coupon and the likely life of the bond before deciding whether a price is fair.
In practice
Real-world examples.
Example
A regional electricity company needs $200,000,000 to build a new plant. It issues bonds secured by a mortgage over its existing power stations, which lets it borrow at a lower rate than an unsecured bond would cost. Bondholders have a claim on the plants if the company fails to pay.
Example
A bank pools 5,000 home loans worth $1,000,000,000 and sells bonds backed by their payments. A pension fund buys a portion for the steady income. Each month the fund receives its share of what homeowners pay in interest and principal. The fund's analysts model how quickly borrowers might repay before deciding how much to buy.
Example
An investor notices that falling interest rates lead many homeowners to refinance. The mortgage bond she holds is repaid faster than expected, and she has to reinvest at lower yields. She learns that prepayment risk is one of the main costs of the extra yield.
Formula
Calculation
Annual Coupon Payment = Face Value x Coupon Rate
Suppose an investor buys $100,000 face value of mortgage bonds with a 5% coupon, paid twice a year. Annual coupon = 100,000 x 0.05 = $5,000. Each half-yearly payment = 5,000 / 2 = $2,500. Over 10 years the investor receives 5,000 x 10 = $50,000 of interest, plus the $100,000 face value back at maturity, assuming the bond is not repaid early.Case study
Seen in the real world.
Stonegate Utilities is an illustrative, fictional water company that needed $150,000,000 for new pipelines. Its treasurer compared an unsecured bond at 7% with a mortgage bond secured on its treatment works at 6%.
On $150,000,000, the one point difference saved $1,500,000 a year in interest. The trade-off was that the treatment works could not be sold or pledged elsewhere without the bondholders' consent.
The board accepted the restriction because the company had no plan to sell the works. The illustrative lesson is that security lowers the cost of debt, but the price paid is a loss of flexibility over the pledged asset. The treasurer also noted that the bond's covenants, meaning the promises made to lenders, required annual reports on the condition of the works.
Watch out
Common mistakes.
- Assuming every mortgage bond is as safe as a government bond, when safety depends on the quality of the underlying loans or property.
- Ignoring prepayment risk, when early repayments can shorten the investment and reduce the income an investor expected.
- Confusing a mortgage bond with a mortgage loan, when the bond is a security sold to investors and the loan is a contract between a borrower and a lender.
Questions
People also ask.
What backs a mortgage bond?
Either a claim on specific property pledged by the issuer, or a pool of home loans whose payments are passed through to investors.
Why do mortgage bonds pay more than government bonds?
They carry extra risks, such as early repayment and borrower default, and investors want to be paid for those risks.
Who buys them?
Pension funds, insurers, banks and other investors seeking steady income often buy them.
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