Types of Bonds
Collateralised Bonds-Securitisation, Structured Products and Covered Bonds
Residential Mortgage Backed Securities (RMBS)
Mortgage securities represent an ownership interest in mortgage loans made by financial institutions (savings and loans, commercial banks or mortgage companies) to finance the borrower’s purchase of a home or other real estate. Mortgage securities are created when these loans are packaged, or “pooled,” by issuers or servicers for sale to investors. As the underlying mortgage loans are paid off by the homeowners, the investors receive payments of interest and principal.
Investors may purchase mortgage securities when they are issued or afterward in the secondary market. Investments in mortgage securities are typically made by large institutions when the securities are issued. These securities may ultimately be redistributed by dealers in the secondary market.
The ability to securitise mortgage loans enables mortgage lenders and mortgage bankers to access a larger reservoir of capital, to make financing available to home buyers at lower costs and to spread the flow of funds to areas of the country where capital may be scarce. Mortgage securities also offer a number of benefits to investors.
With fixed-income securities such as corporate bonds, an investor effectively lends money to the bond issuer in return for a stated rate of interest (the coupon rate) over the life of the bond. The investor receives a repayment of principal—namely, the “face value” of the bond—in a single lump sum when the bond matures.
Investors in mortgage securities also earn a coupon rate of interest, but they receive repayments of their principal in increments over the life of the security, as the underlying mortgage loans are paid off, rather than in a single lump sum at maturity.
Because the timing and speed of principal repayments may vary, the cash flow on mortgage securities is irregular. If homeowners whose mortgages are in a pool sell their homes, refinance their loans to take advantage of lower interest rates, prepay their mortgages for some other reason or default on their loans, the principal is distributed on a pro rata basis to investors in pass-through securities. Investors receive these principal repayments according to the payment priorities and the class of securities they own. When this happens, the investors’ remaining interest in the pool is reduced by the amount of prepayments. Because the principal is reduced over the life of the security, the interest income also decreases in terms of absolute amounts paid to investors.
Mortgage securities are sold and traded in terms of their assumed “average life” rather than their maturity dates. The average life is the average amount of time that will elapse from the date of MBS purchase until principal is repaid based on an assumed prepayment forecast. In other words, average life is the average amount of time a Euro of principal is invested in an MBS pool. However, some mortgage loans could remain outstanding for the entire life of the original loans—typically, 20 to 30 years.
As with any fixed-income security, the yield on a mortgage security investment depends on the purchase price in relation to the coupon rate and the length of time the principal is outstanding.