What are mortgage-backed securities?
Also known as MBS, they're fixed-income investments backed by a pool of mortgages. When a bank lends money to someone to buy a home, it sells that loan to an investment bank, which bundles a lot of loans with similar interest rates together to sell to investors.
Where have you heard about mortgage-backed securities?
President Lyndon B Johnson created mortgage-backed securities in 1968. All was going well until the housing bubble burst in 2007, and US mortgage giants Freddie Mac and Fannie Mae had to be bailed out. Subsequent movies such as The Big Short have put their own spin on the housing meltdown.
What you need to know about mortgage-backed securities...
Mortgage-backed securities generally offer higher yields than other types of bond, but they also involve their own set of risks. There’s the element of prepayment risk when borrowers decide to pay back the principal on their mortgages ahead of schedule. The biggest risk occurs when interest rates rise as some homeowners are caught off guard and default on their mortgages.
To offset the risks, an MBS must be grouped into one of the top two ratings determined by an accredited credit rating agency [link].