Other government agencies and organizations issue securities to fund their own projects. While these bonds often deliver higher returns than Treasury securities because some of them are not explicitly guaranteed by the federal government, they must often be purchased from brokers, incurring a commission. They are considered very safe investments because they would most likely be honored by the government if default occurred. The most common agency bonds are mortgage-backed securities.
Mortgage-backed securities are debt obligations with a pool of mortgages as collateral. They fall into the general category of asset-backed securities, which package a group of securities and offer investors access to the cash flows generated by the underlying securities. An individual investor earns interest in proportion to his stake in the entire pool. Therefore, an investment in a mortgage-backed security is not tied to any one mortgage. The firm that assembles the security takes a small fee and insures the pool against credit risk. One type of mortgage-backed security, the mortgage pass-through security, is identified by the fact that interest and principal payments are passed through to the holder, instead of just interest. Payments to investors are usually made on a monthly basis.
Mortgage backed securities are a relatively low-risk investment vehicle. Securities issued by the Government National Mortgage Association (Ginnie Mae) are particularly safe because they are backed by the full faith and credit of the U.S. government. One downside to these investments is the risk of prepayment by borrowers, or paying back part or all of the loan before it becomes due, which can lower returns by reducing the interest paid on a given mortgage.
Ginnie Mae, Fannie Mae, Freddie Mac and Sallie Mae
The Government National Mortgage Association (Ginnie Mae) is a government-owned agency that buys mortgages from lending institutions, turns them into securities, and then sells those securities to investors. Because the payments to investors are guaranteed by the full faith and credit of the U.S. Government, they return slightly less interest than other mortgage-backed securities.
The Federal National Mortgage Association (Fannie Mae) is a congressionally chartered corporation which buys mortgages on the secondary market, pools them and sells them as mortgage-backed securities to investors on the open market. The securities contain both conventional mortgages and mortgages insured by the Federal Housing Administration. Monthly principal and interest payments are guaranteed by Fannie Mae but not by the U.S. Government.
The Federal Home Mortgage Corporation (Freddie Mac) is similar to Fannie Mae except that none of the pooled mortgages are FHA insured.
The Student Loan Marketing Association (Sallie Mae) creates securities by purchasing student loans instead of mortgages. This is simply another type of asset-backed security.
Collateralized Mortgage Obligations
Collateralized mortgage obligations (CMOs) are backed by mortgage-backed securities with a fixed maturity. They can eliminate the risks associated with prepayment because each security is divided into maturity classes that are paid off in order. As a result, they yield less than other mortgage-backed securities. The maturity classes are called tranches, and they are differentiated by the type of return. A given tranch may receive interest, principal, or a combination of the two, and may include more complex stipulations.
One negative aspect of CMOs is the lower interest rates that compensate for the reduction in prepayment risk and increased predictability of payments. Also, CMOs can be quite illiquid, which can increase the cost of buying and selling them.
Brady bonds arose from an effort in the 1980s to reduce the debt held by less-developed countries that were frequently defaulting on loans. The bonds are named for Treasury Secretary Nicholas Brady, who helped international monetary organizations institute the program of debt-reduction. Defaulted loans were converted into bonds with U.S. zero-coupon Treasury bonds as collateral. Because the Brady bonds were backed by zero-coupon bonds, repayment of principal was insured. The Brady bonds themselves are coupon-bearing bonds with a variety of rate options (fixed, variable, step, etc.) with maturities of between 10 and 30 years. Issued at par or at a discount, Brady bonds often include warrants for raw materials available in the country of origin or other options.