When it comes to investing in the world of personal finance, there are a lot of different options out there. One option that has been growing in popularity over recent years is mortgage-backed securities (MBS). But what exactly are MBS and how can they fit into your investment portfolio? In this tutorial, we’ll take a closer look at MBS and answer some common questions about them.
What Are Mortgage-Backed Securities?
At their most basic level, mortgage-backed securities are investments that are backed by pools of mortgages. These mortgages might be residential or commercial, and they’re bundled together to create a security that investors can buy. When people make their monthly mortgage payments, those payments get passed on to the investors who own the MBS.
There are two main types of mortgage-backed securities: pass-throughs and collateralized mortgage obligations (CMOs). Pass-throughs work just like we described above – when people make their monthly payments on the underlying mortgages, those payments get passed through to the investors who own shares of the security. CMOs are more complex and involve dividing up the underlying pool of mortgages into separate “tranches” with different levels of risk and reward for investors.
How Do Mortgage-Backed Securities Work?
Let’s walk through an example to help illustrate how MBS work:
1. A bank issues a bunch of home loans to individual borrowers.
2. The bank bundles all these loans together into one big package.
3. This package is sold off as an MBS.
4. Investors purchase shares in this MBS.
5. Homeowners continue making their monthly payments on their individual homes.
6. Those payments get funneled back up to the bank that originated the loans.
7. The bank then passes along those payments to the investors who own shares in the MBS.
The key thing to understand here is that when you invest in an MBS, you’re not investing directly in the mortgages themselves. Instead, you’re investing in a security that’s backed by those mortgages.
What Are the Risks and Benefits of Mortgage-Backed Securities?
Like any investment, there are risks and benefits to consider when it comes to MBS.
Benefits:
– Income: One of the biggest draws of MBS is that they can provide a steady stream of income for investors. As homeowners make their monthly payments on their mortgages, that money gets passed along to investors who own shares in the MBS.
– Diversification: If you’re looking for ways to diversify your investment portfolio beyond just stocks and bonds, MBS can be a good option. Because they’re backed by real estate assets (i.e. mortgages), they tend to behave differently than other types of investments.
– Relative safety: While no investment is completely risk-free, pass-through mortgage-backed securities are generally considered relatively safe compared to other types of fixed-income investments like corporate bonds or municipal bonds.
Risks:
– Interest rate risk: One of the biggest risks associated with investing in MBS is interest rate risk. When interest rates rise, homeowners may refinance their loans at higher rates – which means less money coming back to investors who own shares in an MBS.
– Prepayment risk: Another related risk is prepayment risk. If homeowners pay off their loans early (for example, if they sell their homes), again this means less money coming back to investors who own shares in an MBS.
– Credit risk: Finally, there’s always a possibility that some borrowers will default on their loans – which could ultimately lead to losses for investors who own shares in an MBS.
Are Mortgage-Backed Securities Right for Your Portfolio?
So now we come down to the ultimate question – should you invest in mortgage-backed securities? The answer depends on a few factors:
1. Investment goals – Do you need regular income from your investments? Are you looking to diversify your portfolio beyond just stocks and bonds?
2. Risk tolerance – Are you comfortable with the risks associated with investing in MBS, such as interest rate risk or prepayment risk?
3. Investment timeline – How long are you planning on holding onto your investment? MBS may be a good option if you’re looking for steady income over a longer period of time.
Ultimately, whether or not mortgage-backed securities are right for your portfolio will depend on your individual financial situation and goals.
How Do You Invest in Mortgage-Backed Securities?
If you’ve decided that mortgage-backed securities are right for your investment portfolio, the next step is to figure out how to invest in them. There are a few different ways to do this:
1. Directly purchase shares of an MBS – This can be done through a brokerage account.
2. Invest in an ETF or mutual fund that holds MBS – If you prefer a more diversified approach, there are plenty of funds out there that hold mortgage-backed securities alongside other investments.
3. Hire a professional manager – For those who prefer to hand off their investments to someone else, it’s possible to work with a professional money manager who specializes in MBS.
When deciding which approach makes sense for you, consider factors like fees, minimum investment amounts, and overall investment strategy.
Conclusion
Mortgage-backed securities can be an attractive option for investors who want steady income and diversification within their portfolios. Like any investment, they come with risks as well as benefits – so it’s important to carefully evaluate whether they’re the right choice for your own financial situation and goals.
By understanding how mortgage-backed securities work and what factors can influence their performance (like interest rates), investors can make informed decisions about whether or not to include them in their portfolios.