Mortgage Backed Securities are a type of debt which are backed by a pool of mortgage loans. They are also called as Pass Through Certificate. MBS are very popular in United States as they provide better returns when compared to other fixed income securities as investors receives monthly payments that include both principal and interest.
MBS are considered to be safe instrument as they are issued by Government Sponsored Enterprise (GSE) such as Ginnie Mae, Fannie Mae and Freddie Mac. In India, National Housing Bank looks after it.
How MBS works?
1. When a person avails home loan from bank ( mortgage lender). Mortgage lender sells the loan to government sponsored corporation they can can be bank, agencies or private entity.
2. What these agencies do is that they pool number of mortgage loans varying from hundreds to thousands.
3. When home owners make their monthly payment, the pool of mortgages generate cash flows.
4. Then the private entity or Agencies sell claims on the cash flow, in the form securities or bonds to investors.
After the first sale, MBS are traded in open market. As they are actively traded, there are less chances of liquidity risk.
Advantages of MBS
1) Credit quality:
As MBS is issued by government sponsored corporations by full faith of US government. Also, they come with "AAA" credit rating
2) Attractive yields:
As investors payments include both principal and interest that makes them attractive when compared to other alternative fixed income securities.
3) Regular income:
This is best suited for people looking for regular monthly income.
4) Different Maturities:
As they are backed by mortgage securities they have wide range of maturities to meet investors plans and demands.
Disadvantages of MBS
However, interest rates may vary depending the real estate economy. During high interest rates, there are changes of high prepayemnt of homeloans, in turn affecting the mortgage backed securities.