A mortgage bond is a bond secured by a mortgage or pool of mortgages. These bonds are typically backed by real estate holdings and real property such as equipment. In a default situation, mortgage bondholders have a claim to the underlying property and could sell it off to compensate for the default.
Mortgage bonds offer the investor a great deal of protection in that the principal is secured by a valuable asset that could theoretically be sold off to cover the debt. However, because of this inherent safety, the average mortgage bond tends to yield a lower rate of return than traditional corporate bonds that are backed only by the corporation's promise and ability to pay.
When a person buys a home and finances the purchase with a mortgage, the lender rarely retains ownership of the mortgage. Instead, it sells the mortgage on the secondary market to another entity, such as an investment bank or government-sponsored enterprise (GSE). This entity packages the mortgage with a pool of other loans and issues bonds, with these mortgages as backing.
When homeowners make their mortgage payments, the interest portion of their payments is used to pay the yield on these mortgage bonds. As long as most of the homeowners in the mortgage pool keep up with their payments, a mortgage bond is a safe and reliable income-producing security.
Mortgage bond yields tend to be lower than corporate bond yields, as the securitization of mortgages makes such bonds safer investments. If a homeowner defaults on a mortgage, the bondholders have a claim on the value of the homeowner's property. The property can be liquidated with the proceeds used to compensate bondholders. By contrast, investors in corporate bonds have little to no recourse if the corporation becomes unable to pay. As a result, when corporations issue bonds, they must offer higher yields to entice investors to shoulder the risk of unsecured debt.
One major exception to the general rule that mortgage bonds represent a safe investment occurred during the financial crisis of the late 2000s. Leading up to this period, investors realized they could earn bigger yields purchasing bonds backed by subprime mortgages — mortgages offered to buyers with poor credit or unverifiable income — while still enjoying the supposed security of investing in collateralized debt. Unfortunately, enough of these subprime mortgages defaulted to cause a crisis, amid which many mortgage bonds defaulted, costing investors millions of dollars. Since the crisis, there has been heightened scrutiny over such securities. Nevertheless, the Fed still holds a sizable amount of mortgage-backed securities (MBSs) such as mortgage bonds. As of Feb. 8, 2017, the Fed holds $1.74 trillion in MBSs.