Mortgage-backed security

Mortgage backed securities, which include Ginnie Mae Securities (GNMA) and Collateralized Debt Instruments (CDO), are among the most complex securities in the fixed income asset class. Vanguard provides a basic description of mortgage backed securities in the prospectus to its bond funds: "Mortgage-backed securities represent interests in underlying pools of mortgages. Unlike ordinary bonds, which generally pay a fixed rate of interest at regular intervals and then repay principal upon maturity, mortgage-backed securities pass through both interest and principal from underlying mortgages as part of their regular payments. Because the mortgages underlying the securities can be prepaid at any time by homeowners or by corporate borrowers, mortgage-backed securities are subject to prepayment risk. These types of securities are issued by a number of government agencies, including the GNMA, the FHLMC, and the FNMA, [as well as by private issuers]. As a rule, when interest rates rise, bond prices fall. The opposite is also true: Bond prices go up when interest rates fall. Mortgage-backed securities are different. In general, declining interest rates will not lift the prices of mortgage-backed securities—such as GNMAs—as much as the prices of comparable bonds. Why? Because when interest rates fall, the bond market tends to discount the prices of mortgage-backed securities for prepayment risk—the possibility that homeowners will refinance their mortgages at lower rates and cause the bonds to be paid off prior to maturity. In part to compensate for this prepayment possibility, mortgage-backed securities tend to offer higher yields than other bonds of comparable credit quality and maturity."

Definitions
Some definitions useful in understanding mortgage backed securities:


 * Mortgage Backed Security (MBS)
 * Collateralized Mortgage Obligation (CMO)
 * Ginnie Mae - Government National Mortgage Association (GNMA)
 * Pass Through Security
 * Real Estate Mortgage Investment Conduits (REMIC)
 * Tranches

Risks
In addition to the normal risks of bonds, mortgage-backed securities exhibit negative convexity. This negative convexity results from contraction risk--the tendency of homeowners to refinance as interest rates fall--and from extension risk--the tendency of homeowners to delay pre-payments as interest rates rise.

Determining the exact extent of this negative convexity is impossible, as it depends on how mortgagors behave. In general, this behavior is non-linear: small changes make little difference in homeowner behavior but large changes cause homeowners to overcome the hassle and to refinance in larger numbers. The extent of negative convexity can be approximated with statistical modeling, although behavior with large interest rate changes is relatively hard to predict. Bondholders are compensated for this risk by the "option-adjusted spread," which can be interpreted as the market's assessment of the size of prepayment risk.

Detailed discussions can be found at InvestinginBonds.com.

Role in a portfolio
While there is some question as to whether the option-adjusted spread has historically been enough to compensate investors for the increased risk of MBS's, in general there is consensus that the market is efficient at pricing these securities. However, in The Only Guide to a Winning Bond Strategy You'll Ever Need, Larry Swedroe makes the argument that these bonds do not properly diversify the risks of stocks in the portfolio as a whole due to their negative convexity: "In a rising rate environment...MBS will have increasing correlation with equities, and this is not a good thing."

Other Bogleheads hold large allocations of their portfolio in MBS, either by holding Total Bond Market (since a large portion of that fund is in MBS) or directly through the GNMA fund. Jack Bogle has expressed some skepticism of these bonds, calling them "non-bonds."

Holding MBS's as a part of a diversified bond portfolio is unlikely to lead to ruin, and over time investors are likely to be compensated for the increased risk of negative convexity with higher yield. Therefore, investors are justified in investing in MBS's, either directly or through a total bond market fund (which typically are about one-third MBS), provided they understand that they are assuming a moderate amount of additional risk. Investors who do not wish to assume the risk of negative convexity or who are interested in lowering the correlation between the bond component of their portfolio and the equity component are equally justified in sticking to bonds that lack embedded options.

Government and quasi-governmental agencies
GNMA obligations are backed by the full faith and credit of the U.S. Government, just as Treasuries are.

Fannie Mae and Freddie Mac are public companies but are assumed to have the backing of the U.S. Government. This was borne out in the recent (2008) crisis, when the Federal Government did just that. They are therefore considered quasi-governmental agencies.

Corporate
Non-government-backed MBS's are a very small part of the market. GNMA, Fannie Mae, and Freddie Mac hold the bulk of all MBS's.