If you’re interested in getting involved in the real estate market without owning any properties, mortgage-backed securities (MBS) could be an option. These assets are traded in the market and are backed by a bundle of mortgages. This route often carries little risk and can deliver consistent cash flow.
MBS has gained popularity as an investment opportunity. Whether you’re an experienced investor or just starting, this guide will help you navigate the world of MBS effectively. We’ll explain the fundamentals, approaches, and potential of MBS investments so you have the information to diversify your holdings and improve your financial outlook. Let’s set off on our adventure across the MBS universe.
What Is a Mortgage-Backed Security (MBS) and How Does it Work?
Mortgage-backed securities, also known as MBSs, are products that merge mortgages and offer them as a single investment to potential investors. To illustrate, a mortgage provider could package 100 loans into mortgage-backed securities. Present them to investors who meet the criteria established by a government-sponsored entity.
The objective is to provide investors with a steady and predictable stream of income by packaging loans as securities and distributing them among them. Investors receive a pass-through of mortgage repayments. The profitability of this investment does not heavily rely on the performance of any mortgage loan because the loans are pooled together. Mortgage-backed securities, whether issued by government-sponsored entities or private institutions, enable lenders to transfer mortgages to investors.
The original lender may continue to receive payments after a loan has been included in an MBS, but investors take home the cash flow.
Bank A, for instance, might authorize a mortgage and make the loan. The loan is then sold to an aggregator. Investors can purchase an MBS that is made by aggregators and incorporates numerous mortgages. Investors receive the principal and interest while Bank A continues to service the loan, charging a charge for handling the account and collecting payments.
Banks and finance businesses can release capital that will enable them to lend more money to borrowers by selling loans for MBS. Investors have comparatively minimal risk because agency MBS are backed by specific assurances, although there still may be some.
Types of MBS
Mortgage-backed securities come in three main types to suit different investment preferences:
- Pass-throughs: These offer a straightforward structure where investors collectively receive payments from a pool of similar mortgages.
- Collateralized Mortgage Obligations (CMOs): CMOs are more complex, dividing mortgages into classes with varying cash flows and risks to cater to specific investor needs.
- Stripped Mortgage-backed Securities (SMBS): SMBS split payments into principal-only and interest-only classes, providing sensitivity to interest rate changes.
Investors may choose the type that best aligns with their goals and risk tolerance.
How to Invest in Mortgage-Backed Securities
There are two options for Canadian investors to enter the MBS market.
Banks, insurance companies, trust organizations, and credit unions in Canada are among the institutions where you can buy NHA MBS in $5,000 increments with durations of up to ten years. Investors receive a portion of the interest and principal payments associated with the mortgages they have invested in on a regular basis.
Another option to expand your investment scope is by acquiring Canada Mortgage Bonds, which the Canada Housing Trust, a division of CMHC, issues.
Because CMHC completely guarantees the mortgages involved, each type of MBS investing offers an alluring measure of protection.
Because of that assurance, you probably won’t experience the kind of growth linked to more erratic assets. Still, many fixed-income investors are okay with that trade-off.
Terms to Know Before Investing
When considering investing in mortgage-backed securities (MBS), it’s important to keep the following factors in mind;
- Type of Security: Understand the type of MBS, whether it’s a pass-through security or a more intricate collateralized mortgage obligation (CMO).
- Issuer Guarantee: Check for guarantees or credit enhancements and assess the credit quality of the guarantor.
- Quality of Security: Examine the types of mortgage loans in the pool.
- Average Life vs. Stated Maturity: Ensure the average life aligns with your investment horizon.
- YTAL vs. YTM: Compare yield-to-average-life (YTAL) with yield-to-maturity (YTM) for better assessment.
How Do Investors Make Money on Mortgage-Backed Securities?
Mortgage-backed securities also have an impact on investors as some businesses use them to generate profits in the banking industry. Banks and insurance firms often choose mortgage-backed securities as an investment option with low risk, allowing their capital to work effectively for investors.
Let’s consider this scenario: Imagine you invested $200,000 in a mortgage loan for income. If the borrower were to stop making payments, it could put you in a situation. However, if you decide to invest your $200,000 in mortgage-backed securities that consist of a pool of hundreds of mortgages, the impact of one borrower discontinuing payments becomes less significant.
When utilized appropriately, mortgage-backed securities offer an avenue for individuals to participate in the mortgage market while also providing lenders with a stream of funds for mortgages. This ultimately contributes to control over mortgage rates.
How Are Mortgage-Backed Securities Different for Canada?
Canadian mortgage-backed securities (MBS) have distinctions from their US counterparts despite being influenced by structures and regulations.
One notable distinction is that the Canada Mortgage and Housing Corporation (CMHC), a government-owned organization, issues and guarantees MBS. The CMHC facilitates the financing of affordable housing while also offering mortgage insurance. MBSs are frequently issued in the US by private companies like Fannie Mae and Freddie Mac, with or without government support.
The Canadian MBS market is smaller and more concentrated than the US market, which is another distinction. This is partially attributable to the more consolidated Canadian banking system, which fewer dominant major banks characterize. Furthermore, Canada has implemented regulations regarding mortgage lending and securitization. These measures may have played a role in averting some of the practices that led to the downfall of the housing market in the United States back in 2008.
Advantages and Disadvantages of MBS
Advantages:
- Attractive Yield: Mortgage-backed securities offer a fixed, often higher interest rate compared to government bonds and provide monthly payouts.
- Safe Investments: MBSs, especially those guaranteed by the government, are considered low-risk and offer diversification from other markets.
Disadvantages:
- Prepayment Risk: Borrower defaults can lead to losses, and early loan repayments affect expected returns.
- Interest Rate Risk: MBSs are sensitive to interest rate changes, impacting the overall housing market value if rates rise.
Are Mortgage-Backed Securities a Good Investment?
Mortgage-backed securities can be included in a portfolio of investments. Still, individual investors could find it challenging to evaluate the issuer’s creditworthiness. To determine whether an MBS fund is suitable for your financial situation, you should examine the added risk that this complexity entails with a qualified financial advisor.
What Are the Returns on Mortgage-Backed Securities in Canada?
An MBS’s return is a portion of all principal and interest payments made in connection with that specific instrument, with each investor’s return depending on the size of their holding in the MBS.
During the time you have your investment, it’s typical to expect a return ranging from 4% to 6% on the invested amount. You can be confident that your funds are fully protected as they are insured by the Canadian Mortgage and Housing Corporation (CMHC), which is a government division.
Final Thoughts
Canadian Mortgage-backed securities (MBS) offer a way to invest in residential mortgages. With guaranteed payments due to CMHC support, the market is stable and low-risk. Prior to investing, assess risks carefully. We recommend consulting a certified financial counselor to evaluate suitability for your portfolio.
Disclaimer:
This website is provided for information purposes only and is not to be construed as an offer or solicitation for the sale or purchase of securities. No securities regulatory authority has assessed the merits of these securities or the information contained in this website. Potential Investors should conduct their own due diligence before investing. All statements in this website, other than statements of historical fact, that address events or developments that Canguard expects to occur are forward looking statement. These forward-looking statements generally can be identified by the use of words such as “may”, “will”, “expect”, “intend”, “plan”, “estimate”, “anticipate”, “believe” or “continue”, or the negative thereof, or similar variations. Please see the Offering Memorandum for a complete description of the risks associated with investing in Canguard Mortgage Investment Corporation. Purchase of Canguard Shares may be made through Kite Financial Solutions Ltd or a Dealer/Advisor.