Mortgage-backed securities are fixed-income investments that allow investors to purchase an interest in a pool of mortgages. These securities are available from three primary sources: the Federal National Mortgage Association (Fannie Mae, or FNMA), the Government National Mortgage Association (Ginnie Mae, or GNMA) and the Federal Home Loan Mortgage Corporation (Freddy Mac, or FHLMC). These corporations operate with the understanding that mortgage obligations of all three are guaranteed by the federal government. Investors can purchase stocks in all of these corporations, although the securities discussed below are bonds issued by these corporations, not common stock.
These corporations pool mortgages together, creating securities that investors can purchase, giving the investor an investment in the mortgage market. The investor receives interest, as interest is accrued on the outstanding mortgage balances of the mortgages held in the pool. The investor also receives a return of principal, whenever one of the mortgages in the pool is paid off early, such as when a mortgage is refinanced. The investor can either directly purchase a mortgage-backed security, or can invest in a mutual fund that invests in these securities. Henssler Financial generally does not suggest that an investor own these securities. To understand why, take this example:
Assume that mortgage interest rates are currently 8%. A new mortgage-backed security, created by one of the corporations listed above (assume GNMA in this example), would provide investors an approximate yield of 8%, similar to a bond. The security is called a 30-year security, because it is backed by 30-year mortgages. The investor will receive regular interest payments from the security and a return of principal whenever one of the mortgages in the pool is prepaid. Now, consider the effects of either a decrease or an increase in interest rates.
If Interest Rates Decrease
If mortgage rates drop to 6%, most of the mortgages in this pool will be refinanced, as mortgage holders look to lock in lower rates. When this occurs, the GNMA security holders begin receiving back principal that must now be reinvested at lower current interest rates. This has the effect of shortening the average maturity of the GNMA security.
If Interest Rates Increase
If mortgage rates instead increase to 10%, none of the mortgages in the pool likely would be refinanced. Some mortgages will be paid off early, due to homeowners selling their homes. However, in this case, higher interest rates have the effect of lengthening the average maturity of the GNMA security.
Compared to Other Bonds
Unlike other bonds that provide a set interest rate for a set period of time to maturity, the maturity on mortgage-backed bonds moves against the investor in either scenario. As rates rise, the average maturity of mortgage-backed investments increases, locking in the investor at a lower rate of interest for a longer period of time. When rates fall, the average maturity decreases, forcing the investor to find new fixed income investments in a lower interest rate environment.
This is why Henssler Financial suggests that investors avoid mortgage-backed securities. The investor should instead purchase bonds with maturity dates that match the approximate dates the funds will be needed. Because maturity is variable on mortgage-backed securities, they cannot be purchased with a particular maturity date in mind. Therefore, other fixed-income investments should be more appropriate.