Characteristics, Uses and Taxation of Investments - Mortgage-Backed Securities

v. Mortgage-Backed Securities(Asset backed) -
also known as pass-through securities, these are quite simply a repackaging of loans and their income streams, to investors. They constitute a subset of the category of fixed income securities known as asset backed securities (ABS) which pass through the income stream of a particular loan or other type of cash flow to investors. Examples include mortgages, auto loans, music royalties ("Bowie Bonds"), etc. The most common mortgage backed securities, the features of which will receive some treatment on the exam, are known as agency issues because they are issued by agencies of the United States government. In terms of risk, their yields are higher than those of direct obligations of the federal government, but lower than those of corporate bonds. Risks include prepayment if interest rates fall and the underlying assets are repaid more quickly and extended maturity if rates do not. Maturities can be both short and long term. Mortgage-backed issued are subject to federal, state and local taxation. A brief discussion of the various types follows.

  1. Government National Mortgage Association (GNMA or "Ginnie Mae") - the only agency securities backed by the full faith and credit of the United States government, their issuer, GNMA, is a government owned corporation that supports the Department of Housing and Urban Development (HUD). The agency buys Federal Housing Administration and Department of Veterans Affairs mortgages and auctions them to private lenders who, in turn, pool them to create pass-through certificates to sell to investors. These are the mortgage-backed securities. GNMAs pay monthly interest and principal at a yield higher than comparable treasury securities, but with a federal guarantee. The higher yield is due to reinvestment risk since a fall in interest rates will cause the securities to be called away forcing the investor to find a comparable yield elsewhere. The minimum purchase is $25,000.
  2. Farm Credit System (FCS) - a national lender network providing agricultural financing and credit, FCS is privately owned, but government sponsored and repackages loans to farmers. The bonds range from short to long term (up to thirty years) and are issued at a discount. Interest is exempt from state and local taxation, but is subject to federal taxation.
  3. Federal Home Loan Mortgage Corporation (FHLMC or "Freddie Mac") - a corporation publicly traded on the New York Stock Exchange, its purpose is to promote a secondary mortgage market by buying residential mortgages from financial institutions and repacking them into mortgage-backed securities. Two types of pass-throughs are offered. Mortgage participation certificates (PCs) make monthly interest and principal payments; Guaranteed Mortgage Certificates (GMCs) make interest payments semi-annually and principal payments annually. Interest is subject to federal, state and local income tax.
  4. Federal National Mortgage Association (FNMA or "Fannie Mae") - FNMA trades on the NYSE. IT purchases mortgages from the FHA and VA, repackaging them for resale to investors. They are backed by the FNMA's general credit, not that of the United States government. Interest income is taxed at all levels.
  5. Student Loan Marketing Association (SLMA or "Sallie Mae") - SLMA trades on the NYSE. It issues discounted notes and short-term floating rate notes (six month maturities). Proceeds fund student loans for higher education. Interest income is taxable at the federal, but not the state or local levels.
  6. Collateralized Mortgage Obligations (CMOs) - a mortgage backed security issued by private financing corporations that pools mortgages on single-family residences. These mortgages are structured into tranches or maturity classes. The term is used interchangeably with Real Estate Mortgage Investment Conduit (REMIC) which enables investors to avoid double taxation. Because of backing by such agencies as GNMA and FNMA, CMOs often carry a AAA credit rating. CMOs pay principal and interest on a monthly basis from the mortgage pool, repaying principal to one tranche at a time, but interest to all tranches at the same time. Neither the maturity, interest or principal are guaranteed owing to the fickle nature of mortgage prepayments. They are subject both to prepayment and extension risk, issued in $1,000 denominations and are subject to federal, state and local income tax. A brief review of the most common CMOs follows.
    1. Plain Vanilla: interest paid on all tranches simultaneously, but to principal one tranche at a time until the tranche is retired.
    2. Principal Only (PO): receives income from principal payments, both scheduled and prepaid, is issued at a discount to par and rises and falls in inverse relation to interest rates.
    3. Interest Only (IO): receives income from interest payments which decline over time, is issued at a discount and rises and falls in direct relation to fluctuating interest rates, making it a suitable hedging tool against interest rate risk in a portfolio. High prepayments translate into fewer interest payments to IO holders.
    4. Planned Amortization Class (PAC): with targeted maturity dates, they are retired first, affording the holder a defense against both prepayment and extension risks. Prepayment changes are laid off on support tranches.
    5. Targeted Amortization Class (TAC): prepayment risk is transferred to a companion tranche, offering no protection from extension risk. As a result, TACs pay a slightly higher rate of interest.
    6. Zero-Tranche (Z-Tranche): receives payment once all preceding CMO tranches are retired.
Zero-Coupon and Municipal Bonds
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