NOTE: I have changed the title of IBC–or Investment Boot Camp–to “Investment Primer”. That might make it easier for readers to better understand what that series of blog posts is about.
Some retirees and other investors, who seek regular income, like the higher cash flow provided by bonds that are collateralized by mortgages. The underlying “pools”, composed of thousands of mortgages, are packaged and sold into the bond market. That frees-up the mortgage-originating banks’ capital, which can then be used to make additional loans.
This is good for the banks, since they make more money on mortgage originations, and it enhances the liquidity in the overall banking system. There are additional risks, however, that many investors are unaware of.
Unlike most bonds, which repay the principal on the loan only upon maturity, MBS’s pass the principal and interest monthly payments through to the investors. That “self-amortization” feature, however, adds to the above-mentioned risks for mortgage-backed securities.
Investors sometimes sell their MBS’s, for whatever reason; so, the potential value that can be realized, in the secondary (or re-sale) market is of importance in making that decision. Now, two basic rules of bond investments are important to consider: bond prices move inversely to interest rates, rising when rates decline, and dropping when interest rates increase. Also, the sensitivity to rate changes increases or decreases proportionately along with the anticipated maturity period.
Some homeowners occasionally make additional partial principal repayments over the life of their mortgages. Others may repay the debt in total, either with excess cash or to move to another home. Due to the self-amortization feature of mortgages, establishing a viable secondary market, would be impossible without some idea as to the investments term until maturity.
Since mortgage-backed securities are collateralized with thousands of mortgages, the law of averages allows for the concept of the “half-life”–the projected term upon which half of the underlying principal would be repaid. That projected half-life enables a secondary market price to be estimated and, thus a re-sale market to be established.
The additional market risk with MBS’s, especially in a rising interest environment, is called “extension risk”. Initially, the half-life on a pool of mortgages is generally expected to be approximately twelve years. That assumes some of the principal on the pool of mortgages will be repaid earlier than scheduled.
Most investors are unaware of how extension risk can impact the half-life, and thus the market risk on their bonds. That risk is generally not fully disclosed since most brokers don’t sufficiently understand it themselves. And, if the early repayment of principal is even mentioned, it is often incorrectly referred to as the “average life”.
Let’s consider how a rising interest rate environment might effect the re-sale value of two bonds: a traditional bond, due in twelve years; and a mortgage-backed security with a twelve-year half-life. And, six years later, the investor wishes to sell the bonds.
The traditional bond would then have six years until maturity before the debt would be repaid. Accordingly, it would be priced off of other bonds with six-year terms. For a MBS in an increasing rate environment environment, however, the mortgage prepayments would be expended to decline, thus extending the half-life, and reducing the bond’s secondary market value. It would then be priced off of somewhat longer-term bonds.
There can also be a generally somewhat lesser risk in the event that interest rates decline. As an investor, you benefit when interest rates decline since your bond pays more than newer issues. However, lower rates means that mortgage prepayments can accelerate, and that reduces the half-life of the bond. Thus, the additional cash flow runs-out even sooner than anticipated. The market value would decline accordingly.
Mortgage-backed securities may be good investments for some investors. With any investment, however, it is important to know what the risks are in your portfolio. That way, you can monitor them a bit more closely.