After all of this talk about complex, risky, unfamiliar investment options, here is a safe and easy alternative. Just call your stock broker and buy a mortgage-backed security (“MBS”), such as a Ginnie Mae (GNMA), which is guaranteed by the United States government. It is a bond, so it generates a stream of income and is guaranteed to return your principal over a period of years.
The bond is backed by a huge pool of mortgages, and as the debtors pay their mortgages, a piece of the interest and principal is distributed to you as a bond holder on an amortized basis. If you just hold the bond until the end of its term, you are guaranteed to get all of the interest and all of your principal back. No risk. No work, no specialized knowledge required.
So, what’s the catch? There is always a catch! Investments like this with low risk always offer low reward. In the current market, an MBS with an anticipated paydown period of three to six years will only earn about 3 percent interest. You can earn a slightly higher yield if you extend the term out for a longer period of years.
The risks are very low. Your principal and interest payments will be safely paid to you.
There is no risk of default if you buy GNMA bonds because they are guaranteed by the federal government. If a debtor defaults on one or more of the mortgages that are bundled together in your bond, it has no effect on you—the government incurs the loss. The only questions:
- When will all of your principal be returned?
- Will you miss out on higher interest rates while you are waiting for your bond to be repaid?
The term of the bond is flexible because it depends on repayment of the mortgages that make up the trust. If many people pay off their mortgage early, through sales or refinancing for example, your investment will be returned more quickly. If the debtors do not pay back their mortgages early, your investment funds will be paid back to you a bit more slowly, but you will receive interest payments until you are fully paid off.
Summary Points
- No Specialized Knowledge: Just call your stock broker or financial advisor.
- Reasonable Capital Requirement: Bonds can be bought for as low as $1,000.
- Scalability: Yes. There is an enormous supply of bonds for investors.
- Liquidity: The bonds can be sold, but depending on the current market interest rate, your bonds may be worth more or less than you paid.
- No Barriers to Entry: Just call your broker or financial advisor.
Risks
The main risks relate to how interest rates may move in the free market. If you do not sell your MBS bond, regardless of how interest rates fluctuate in the general market, you are guaranteed to receive your principal and interest when the bond matures. The interest rate is “fixed” for these bonds, so they will not fluctuate up or down with the market. This is favorable when prevailing interest rates are falling in the market, since you will continue to earn your “fixed rate interest.” The concern is that if market interest rates rise sharply, you are still locked in at your “fixed rate” of interest, and you will be anxious to get your money back so that you can reinvest in new bonds at a higher rate of interest.
Three Possible Scenarios:
- Interest Rates Rise. Fewer debtors will refinance their mortgages, so it will take longer for bonds to be paid off, and investors will have to wait longer to take advantage of the higher interest rates by buying new bonds.
- Interest Rates Decrease. More debtors will pay off their mortgages by refinancing at a lower rate, so bond investors will be paid off sooner.
- Interest Rates Stay the Same. The MBS bonds will be paid off as expected, and the investors will reinvest at about the same rate.
There is no risk of default for GNMA bonds because they guaranteed by the full faith and credit of the United Sates. As discussed below, there is some risk of default for other types of MBS bonds depending on which agency or entity issued the bonds.
Some Terminology
Here are some terms and acronyms that are commonly thrown around:
ABS: Asset-Backed Security is a bond that is secured by an asset such as a mortgage. An MBS is a type of Asset Backed Security.
MBS: Mortgage-Backed security, like GNMA or FNMA.
RMBS: A mortgage-backed security that holds mortgages on residential properties such as single and two-family homes.
CMBS: A mortgage-backed security that holds mortgages on commercial properties such as office buildings, stores, and apartment buildings.
Principal: Borrowed funds.
Interest: Money paid to a lender for the use of borrowed funds.
Market Interest Rate: The prevailing interest rate for a given duration as set by trading on a market.
Tranche: French word for “slice.” Often used in discussing how MBS pools are sliced up into different parts for distribution of payments.
Securitization: Pooling various types of debt such as mortgages, and selling the cash flow to investors as bonds. The type of debt (such as mortgages or unsecured credit card debt) impacts the risk of the bonds
Average Life: Average predicted period in which a debt is repaid through amortization.
How is This Done?
Thousands of mortgages are grouped together into a trust, and as the debtors make monthly payments on the mortgages, the funds are pooled and distributed to the bond holders in accordance with the term of the MBS security.
The mortgage payments include interest and principal, so as payments are collected and distributed each month, a portion of the principal is returned to the investor along with the accrued interest.
This continuous return of principal has advantages and disadvantages. Investors like to get principal back early when interest rates are rising, because the funds can be reinvested into a new higher-yielding bond. But when interest rates are falling, the returned funds must be invested into a new bond with a lower yield.
Also, as the principal is returned in small portions each month, it usually sweeps into a money market fund (which earns very low interest) until it accumulates enough to buy another bond. This may seem petty, but the uninvested funds are not working for you, and they reduce your interest income.
Other types of bonds such as municipal bonds or corporate bonds do not share this problem because all principal is paid back at once at the end of the bond term, so the investor accrues interest for the entire term.
Just Call Your Broker
Buying a MBS bond is very easy. Just call your financial advisor or broker and ask to speak with a broker who specializes in bonds. The process to buy is similar to buying a stock. It gets a little more complicated when deciding which MBS bond to buy because the bonds differ based on what entity issues the bonds and how the MBS is structured.
(To be continued...)
This excerpt is taken from “How to Invest in Debt: a Complete Guide to Alternative Opportunities” by Michael Pellegrino. To read other articles of this book, click here. To buy this book, click here.
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