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Government-Backed Mortgage Securities and Agency Bonds

(Look under US Government Agency Bonds in bondonline link):

What Are Government-Backed Mortgage Securities?

When consumers take out government-backed mortgages from banks and other lenders, the loans are pooled, repackaged and sold to the public (and to funds, etc.) in the form of mortgage securities (“pass-through certificates”). These are offered by the Government National Mortgage Association (GNMA or “Ginnie Mae”), “supported by the full faith and credit of the U.S. government, ” and by the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC), nicknamed Fannie Mae and Freddy Mac, both former government agencies, now publicly traded companies.

Fannie and Freddie are rated AAA, but it is worth reading news stories about accounting practices and questionable loan portfolios, since these companies do not have the same government guarantees as the HUD-based GNMA.

How Do I Buy Mortgage Securities?

GNMA bonds can be bought periodically as new issues for a minimum of $25,000. Fannie and Freddie bonds can be bought in $1000 increments, and new issues are available (with no commission at some brokerages). All can be bought and sold on the open market, although Fannie and Freddy bonds are more common.

How Do Mortgage Securities Work?

Although mortgage securities are issued with a maturity date and coupon payment, like other bonds, they are different in having continuous call provisions and paying off the principal in bits and pieces.

When a homeowner sells a house, pays off a mortgage early, or refinances, the mortgage ends, and a portion of a mortgage security that owns that mortgage gets called. The bondholder then receives part of the principal, and future interest payments are based on the remaining principal. By time a 30-year mortgage security matures, there may be little left of the principal to be returned.

Are Mortgage Securities a Good Investment?

Historically, mortgage securities have been popular with investors, because they have paid higher interest (around 100 basis points more on the average) than long and intermediate term Treasuries, with almost as little risk of default. Even the periodic prepayment of principal was manageable, since it came in gradually over a long time.

However, historically most people took out 30-year mortgages and moved infrequently. Now, adjustable rate and “creative” mortgages are a widely used, homeowners refinance frequently to take advantage of lower interest rates or to cash out the equity in their homes, and moving is commonplace. The result is that mortgage securities are much more subject to being called in bits and pieces than in the pass.

Refinancing tends to occur much more frequently when interest rates are declining. This means the bondholder is likely to have large portions of the principal returned when “reinvestment risk” (lower yields) is high.

On the other hand, refinancing is less likely when interest rates are going up, while the tradable value of the bond is going down. This does not affect those who hold the bond to maturity, but the combination of refinancing during declining interest rates and loss of value during rising interest rates takes a considerable toll on bond funds that hold mortgage securities.

Do Other Government Agencies Offer Bonds?

Bonds are issued by other government agencies, such as the Tennessee Valley Authority (TVA). These are AAA bonds, usually with call provisions, but without the continuous call and refinancing risk of mortgage securities. Look for listings under “Agency Bonds.”
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