What Are the Different Types of Mortgage Bonds?

Mortgage bonds are debt instruments that play a significant role in the broader financial market. These securities allow investors to receive income derived from the payments made on pooled mortgage loans. By investing in mortgage bonds, investors gain exposure to the housing market without directly owning individual properties or originating loans. This investment vehicle transforms illiquid mortgage loans into marketable securities, providing a pathway for capital to flow into the housing sector.

Understanding Mortgage Bonds and Securitization

A mortgage bond represents an investment in a pool of mortgage loans, where the bond’s cash flows are directly linked to the principal and interest payments made by homeowners. The creation of most mortgage bonds involves a process known as securitization.

The securitization process begins with a mortgage originator, which issues the initial mortgage loans to borrowers. These originators then sell large quantities of these loans to an issuer, often a government-sponsored enterprise or a private financial firm. The issuer pools thousands of mortgages, forming a diverse collection of loans. This pool then serves as collateral for the newly created securities.

Next, the issuer structures these pooled mortgages into bonds, which are then sold to investors. A mortgage servicer collects monthly payments from homeowners, handling delinquencies and forwarding cash flows to the issuer. The issuer then distributes these payments, after deducting fees, to investors. This process allows lenders to remove loans from their balance sheets, freeing up capital for new lending, while providing investors with opportunities to earn income from mortgage payments.

Pass-Through Mortgage-Backed Securities

Pass-through securities represent a type of MBS where investors receive a proportional share of the principal and interest payments from a pooled group of mortgages. These payments are “passed through” from borrowers, after deductions for servicing and guarantee fees. This means investors own a direct interest in the cash flows from the mortgage pool.

Pass-through MBS are susceptible to prepayment risk. This risk arises when homeowners pay off their mortgages earlier than expected, either by refinancing at lower interest rates or selling their homes. When prepayments occur, the bond’s principal is returned to investors sooner, potentially forcing reinvestment at lower rates and affecting yield. Conversely, if interest rates rise, homeowners may delay refinancing, leading to slower prepayments and extending the bond’s average life.

Government-sponsored enterprises (GSEs) like Ginnie Mae, Fannie Mae, and Freddie Mac issue agency pass-through MBS. These agencies acquire mortgages from originators and issue securities backed by them. Ginnie Mae guarantees timely payment on its securities, backed by the U.S. government, for mortgages insured or guaranteed by federal agencies. Fannie Mae and Freddie Mac also guarantee timely payment on their securities, with implicit government backing. These guarantees enhance the credit quality of agency MBS, making them attractive to a broad range of investors.

Collateralized Mortgage Obligations (CMOs)

Collateralized Mortgage Obligations (CMOs) are complex mortgage bonds that manage prepayment risk among different investor classes. Unlike simpler pass-through securities, CMOs segment the cash flows from a mortgage pool into multiple classes, known as “tranches,” each with distinct payment priorities, maturities, and risk. This structuring aims to create more predictable cash flows for certain tranches, appealing to diverse investor needs.

CMOs distribute principal and interest payments from the mortgage pool to tranches based on predetermined rules. Senior tranches receive payments first, offering greater safety, while junior or subordinated tranches receive payments later, carrying higher risk but potentially higher returns. This hierarchical payment structure allows for a tailored allocation of prepayment risk, where some tranches are protected, and others absorb the volatility.

Sequential pay tranches

Sequential pay tranches are the simplest CMOs. Each tranche receives interest, but principal payments go to the first tranche until it is paid off. Once the first tranche is retired, principal payments flow to the next tranche in sequence until it is paid off, and so on. This sequential retirement provides a predictable payment order, with earlier tranches having shorter average lives.

Planned Amortization Class (PAC) tranches

Planned Amortization Class (PAC) tranches are structured to provide predictable cash flows within a specified range of prepayment rates. They achieve this by having a defined principal repayment schedule; prepayments outside this range are absorbed by companion or support tranches. This protection against both faster and slower prepayments makes PAC tranches attractive to investors seeking more stable cash flows.

Targeted Amortization Class (TAC) tranches

Targeted Amortization Class (TAC) tranches offer a fixed principal payment schedule, similar to PACs, but their certainty applies only to a single, targeted prepayment rate. If actual prepayments deviate from this single rate, TAC tranches offer less protection than PACs and can experience either accelerated or delayed principal payments. While providing more cash flow stability than a regular CMO, TACs offer less protection against prepayment variability compared to PAC tranches.

Z-Bonds

Z-Bonds, or accrual bonds, are CMO tranches that do not pay current interest to investors. Instead, interest accrues and is added to its principal balance, allowing it to grow. Z-bonds only receive principal and interest payments after all other tranches in the CMO structure are paid off. Due to their subordinated position, Z-bonds carry higher risk but can offer higher yields.

Interest-Only (IO) and Principal-Only (PO) tranches

Interest-Only (IO) and Principal-Only (PO) tranches strip the interest and principal components of mortgage payments into separate securities. An IO tranche receives only the interest payments from the underlying mortgage pool, while a PO tranche receives only the principal payments. The value of an IO tranche increases when interest rates rise (and prepayments slow), as more interest payments are collected over a longer period. Conversely, a PO tranche’s value increases when interest rates fall (and prepayments accelerate), leading to faster receipt of principal. These stripped MBS can be standalone securities or incorporated as tranches within a broader CMO structure, offering investors specialized exposure to interest rate movements and prepayment speeds.

Other Major Mortgage Bond Categories

Beyond CMOs, mortgage bonds are categorized by issuer, collateral, and structural features. These distinctions provide further insight into the diverse landscape of mortgage-related investments.

Covered bonds are debt instruments issued by banks or mortgage institutions, secured by a pool of assets, typically mortgage loans, that remain on the issuer’s balance sheet. Unlike traditional mortgage-backed securities (MBS) where the underlying loans are sold to a separate entity, covered bond investors have “dual recourse”—a claim against both the issuer and the segregated pool of collateral in the event of the issuer’s default. This additional security means the issuer remains obligated to pay bondholders, and if the issuer fails, investors can access the cover pool. The collateral pool for covered bonds is dynamic, allowing for replacement of non-performing assets, which further enhances their safety profile.

Mortgage bonds are also distinguished as agency and non-agency. Agency MBS are issued or guaranteed by government-sponsored enterprises (GSEs) like Ginnie Mae, Fannie Mae, and Freddie Mac. These bonds carry a guarantee of timely payment, giving them higher credit quality due to government or quasi-government backing. In contrast, non-agency MBS are issued by private financial institutions and do not carry such government guarantees. Consequently, non-agency MBS entail higher credit risk but may offer higher yields to compensate investors.

Mortgage bonds are also categorized by collateral type: Residential Mortgage-Backed Securities (RMBS) and Commercial Mortgage-Backed Securities (CMBS). RMBS are backed by residential mortgage loans, typically for single-family or multi-family homes. These securities are influenced by factors affecting individual homeowners, such as interest rate changes influencing refinancing decisions.

CMBS are backed by mortgages on income-producing commercial properties, including office buildings, retail centers, hotels, and apartment complexes. CMBS often feature a non-recourse nature, meaning the lender’s claim in default is limited to the collateral property itself, not the borrower’s other assets. CMBS structures also commonly involve special servicers who manage distressed loans and foreclosed properties within the pool, a feature less prevalent in RMBS.