How to Buy Mortgage Bonds: What You Need to Know

Mortgage bonds are debt securities offering fixed-income investments, with income derived from payments on underlying real estate mortgages. This article guides understanding and purchasing mortgage bonds.

Understanding Mortgage Bonds

Mortgage bonds are debt securities backed by a pool of residential or commercial real estate mortgages. Investor income comes from collective principal and interest payments made by homeowners. If borrowers default, bondholders can claim the real estate collateral to recover their investment.

The market includes Agency Mortgage-Backed Securities (MBS), issued or guaranteed by government-sponsored enterprises (GSEs) like Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), or by a U.S. government agency like Ginnie Mae (Government National Mortgage Association). Ginnie Mae securities carry the full faith and credit of the U.S. government. Fannie Mae and Freddie Mac, as GSEs, have an “implicit guarantee,” meaning the market assumes government intervention would prevent their default, though no explicit guarantee exists.

Non-agency MBS are issued by private entities without government backing; their credit risk depends solely on the issuer and underlying mortgages. Collateralized Mortgage Obligations (CMOs) are complex derivatives that divide mortgage pools into tranches with varying maturities and payment priorities. Agency MBS are generally the primary focus for most investors due to their lower credit risk.

Key Considerations Before Investing

Before investing in mortgage bonds, evaluating several factors is important to understand potential risks and returns. These factors influence the bond’s value and expected income, aiding informed investment decisions.

Prepayment risk is the risk that borrowers pay off mortgages earlier than expected, often when interest rates decline and homeowners refinance. When prepayments occur, principal is returned sooner, requiring reinvestment, potentially at lower rates, which can reduce overall returns. This risk is particularly relevant for mortgage-backed securities because underlying loans can be paid off at any time, impacting the predictable income stream.

Interest rate risk is another important consideration. Bond prices and interest rates generally have an inverse relationship; when rates rise, existing bond values fall, and conversely, when rates fall, bond values tend to increase. This sensitivity means economic changes directly affect a mortgage bond’s market value. Understanding how current interest rate trends might impact future bond prices is important for assessing this risk.

Yield refers to the return an investor receives from a bond. Various yield metrics exist, such as stated yield (coupon rate), yield to maturity (YTM), and yield to worst (YTW). YTM considers total return if held to maturity, while YTW accounts for the lowest possible yield if embedded options like prepayment are exercised. These metrics provide different perspectives on potential income and should be analyzed to align with investment goals.

Duration measures a bond’s sensitivity to interest rate changes, expressed in years. A higher duration indicates greater price volatility in response to interest rate fluctuations. For instance, a bond with a five-year duration might see its price decrease by approximately 5% if interest rates rise by 1%. This metric helps investors gauge the level of interest rate risk. Investors anticipating rising rates might prefer shorter-duration bonds to mitigate potential price declines.

Credit quality assesses the likelihood that the bond issuer will make timely interest and principal payments. For Agency MBS, the implicit government backing or explicit guarantee provides high creditworthiness. For non-agency mortgage bonds, evaluating the creditworthiness of the issuing entity and underlying mortgages is essential, as these lack government support.

Liquidity refers to how easily a bond can be bought or sold in the market without significantly affecting its price. Agency MBS are generally considered highly liquid, with substantial trading volume. Other types of mortgage bonds, particularly non-agency or more complex structures, might have lower liquidity, meaning they could be harder to sell quickly without a price concession.

Interest income received from mortgage bonds is generally subject to federal income tax. Depending on the issuer and state laws, some income may also be subject to state and local income taxes. Investors should consult tax professionals to understand how this income will be treated for their specific tax situation.

Methods of Purchase

Investors can access mortgage bonds through several practical avenues, each offering different levels of diversification and management. The choice of purchase method depends on an investor’s preferences for direct control versus professional management and diversification.

One common approach is investing through mutual funds that specialize in mortgage-backed securities. These funds pool money from many investors to buy a diversified portfolio of mortgage bonds. Mutual funds offer diversification and professional management, which can be beneficial given the complexities of prepayment and interest rate risks. However, they typically charge management fees.

Exchange-Traded Funds (ETFs) that track mortgage bond indices provide another accessible option. ETFs combine features of mutual funds and individual stocks; they offer diversification and professional management. They can be traded throughout the day on exchanges, offering flexibility for investors who prefer to buy and sell during market hours.

Direct purchase of individual mortgage bonds through a brokerage account is also possible, primarily for Agency MBS. This method allows investors to select specific bonds that align with their investment criteria. However, buying individual bonds typically requires higher minimum investments than funds and offers less inherent diversification, as the investor is responsible for building their own portfolio of bonds.

While less common for individual retail investors, some direct purchase programs from government agencies may exist. For the general public, mutual funds, ETFs, and direct brokerage purchases of Agency MBS are the most common and practical channels for accessing this asset class.

Executing Your Purchase

Once you identify your preferred investment method, the next step is executing your purchase. This guide outlines typical steps for funds or individual bonds through a brokerage, assuming research and investment decisions are complete.

Opening a brokerage account is the initial step. This involves providing personal information like your name, address, Social Security number, and citizenship details, as required by “know your customer” (KYC) regulations. Applications are often online; some firms have minimum deposit requirements, but many allow accounts with no initial minimum.

After establishing your account, fund it using Automated Clearing House (ACH) transfers from a linked bank account or wire transfers. ACH transfers typically take a few business days, while wire transfers offer faster access, often within 24 hours, though they may incur a fee.

With funds in your account, research and select investments using the brokerage platform. For mutual funds or ETFs, search by ticker symbol. For individual bonds, use a bond search tool to filter by issuer, maturity, or yield, often identifying bonds by their CUSIP number. A CUSIP is a unique nine-character alphanumeric code identifying U.S. and Canadian securities.

Placing an order involves specifying the investment and quantity. Choose between a market order or a limit order. A market order instructs the broker to buy or sell immediately at the best current price, guaranteeing execution but not a specific price. A limit order allows you to set a maximum purchase or minimum selling price, executing only if that price or better is met, though execution is not guaranteed. For bonds, a limit order can help control the price.

After placing your order, you will receive a trade confirmation. The transaction then proceeds to settlement, the official transfer of ownership and funds. For most securities, including bonds, the standard settlement period is T+1, meaning the trade settles one business day after the transaction date. Regularly monitor your investment by reviewing statements and tracking performance through your brokerage account.