A mortgage bond is a bond secured by a mortgage, or a pool of mortgages on a property, such as a house. It may also be backed by equipment that can be liquidated.
If there is a default, the mortgage bond holders have a claim on the property that backs the bond – they can sell it off to get their money back.
Mortgage bonds typically pay interest monthly, every quarter, or semiannually.
Mortgage bonds are seen as super-secure investments because assets (property) can be sold off to cover the debt. However, as is always the case when risk is lower, they generally yield a much smaller rate of return compared to traditional corporate bonds.
Why do mortgage bonds exist?
When most people buy their home, they usually need to take out a loan from a bank or mortgage lender. In order to get this mortgage, they need to sign a promissory note stating that they will pay back what is lent to them, plus a certain amount of interest, which is added on each month.
In most cases, the monthly mortgage repayments continue for several years, possibly up to thirty years.
To be able to grant these loans, the mortgage lender may need to borrow lots of cash from larger financial institutions. The mortgage lender offers a number of mortgage agreements in a one lump-sum package to a financial institution, which in return issues a mortgage bond.
The larger financial institution actually ‘buys’ the mortgage agreement from the mortgage lender and is paid by the borrower in monthly payments in exchange.
Through the mortgage bond process, the mortgage lender gets the money it needs to grant home loans to its customers, while the larger financial institution earns the additional money by being paid every month by the borrower.
If the mortgagor (borrower) defaults on the home loan, the financial institution that issued the mortgage bond is liable for the loss. To get its money back, the financial institution that issued the mortgage bond can resell the property. However, if house prices have declined, it will not get all its money back.
Video – What is a mortgage bond?