What is a Mortgage-Backed Revenue Bond

Mortgage-backed revenue bonds are debt securities used to fund mortgages. The mortgage payments collected from the funded loans provide the bond’s coupon payments.

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Understanding Mortgage-Backed Securities

BREAKING DOWN Mortgage-Backed Revenue Bond

Mortgage-backed revenue bonds are a type of debt security issued to obtain funding for low-interest-rate mortgages. In essence, the entity issuing the loan outsources mortgage funding to the bondholders, who get paid a coupon based on the mortgage interest rate. Municipalities commonly issue these types of bonds through housing finance agencies.

Revenue bonds generally refer to a subset of municipal bonds where the borrowed funds go toward a revenue-generating project or investment. The revenues generated from the investment, in turn, back the payments to bondholders. Because their repayments get tied to a specific income stream, revenue bonds carry greater risk than general obligation bonds, which municipalities repay through an array of sources, including tax revenue. In theory, that additional risk should generally provide investors with a better yield from a revenue bond versus a general obligation bond.

In the case of mortgage-backed revenue bonds issued by a housing finance agency, also known as housing bonds, investors typically receive tax-free interest. This tax-advantaged treatment allows the bonds to remain attractive, despite returning lower interest rates in line with the mortgages that back them.

Municipalities find mortgage-backed revenue bonds attractive because they generally provide social benefits within the community. By backing the issuance with low-interest-rate mortgages, for example, municipalities can provide assistance to low-income first-time homebuyers who may not otherwise be able to afford the monthly payments associated with a standard mortgage. Bond proceeds could also go toward financing other types of real estate development, such as affordable rental housing. In those cases, the developer makes interest payments funded by rent collected on the property.

Investment Considerations

As with any revenue bond, investors must take care to ensure that they receive appropriate compensation for the risk they take in purchasing the investment. Potential for default on mortgage loans remains a risk in any bond backed by real estate, even when the loans go below market rate. The quality of underwriting matters when investing in a mortgage-backed revenue bond. Likewise, the duration of the bond may vary. Most cover a short term, further reducing the default risk involved in any given issuance, and keeping interest rates relatively low.

The tax advantages provided by housing bonds can also offset the risks involved. From an investor’s standpoint, the value of tax-exempt interest derives from the actual amount of tax saved compared to a similar investment. Therefore, the value of tax-exempt interest rises alongside an investor’s marginal tax rate.