NEW MORTGAGES are often securitized, meaning they’re packaged into bonds and sold to investors. An attractive investment? Mortgage bonds should yield more than comparable government bonds, in part to compensate investors for so-called prepayment risk.
That’s the risk that homeowners will pay off their mortgages early, perhaps because they move or refinance or, alternatively, by making extra principal payments. That early mortgage payoff is more likely to occur if rates fall. Homeowners with older, higher-interest-rate mortgages realize they could do better, so they refinance or pay ahead on their loan.
That creates an asymmetry in how mortgage bonds perform. When rates rise, mortgage bonds are likely to fall, just like other bonds. But if rates fall, mortgage bonds may not perform as well as other bonds, because of those prepayments. If you own mortgage bonds, what you really want is for interest rates to stay relatively constant.
Looking for a low-cost mortgage-bond fund? Check out mutual funds such as Fidelity GNMA Fund, Vanguard GNMA Fund and Vanguard Mortgage-Backed Securities Index Fund, and ETFs like iShares MBS ETF, SPDR Portfolio Mortgage Backed Bond ETF and Vanguard Mortgage-Backed Securities ETF.
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