Yesterday, another article on bonds and risk discussed the fact that while bonds and other fixed-income securities have earned a reputation as being less risky than stocks, that doesn't mean they don't have any risk at all. Historically, while stocks have sometimes had some extremely dramatic fluctuations in value, bonds have also endured similar spells of volatility, albeit with slightly smaller oscillations. Contrary to the pronouncements of some financial marketing materials, it's possible for you to lose money by investing in bonds.
To understand fully the risks involved in owning bonds, you need to understand the way bond prices are calculated. Most investors don't have much trouble intuitively understanding the way stock prices move. If a company is doing well by increasing sales and earnings, then most of the time, its stock price will go up. Bond prices, however, are a little trickier, as they fluctuate with a host of factors that don't necessarily have anything specific to do with the entity issuing a particular bond. As fellow Fool S.J. Caplan explains very clearly in her article on bond risk, investors face a number of perils that can adversely affect the value of their investments, including interest-rate risk, the risk of a bond being called early, default risk, the risk of inflation, and the potential risk of not being able to find a buyer if you have to sell the bond prior to maturity.
Bond prices and interest rates
In general, the prices of existing bonds move in the opposite direction of the movement in interest rates. For example, as interest rates have come down over the past several years, most bond prices have moved higher in response. At first, this may seem counterintuitive, as you might think that higher interest rates would mean more income for bond owners, and so the value of those bonds would rise as a result. However, keep in mind that most existing bonds have fixed terms that don't allow the bond's interest rate to change prior to its maturity. So in simple terms, the value of existing bonds goes down when interest rates go up because the investor is getting less interest than a new bond would pay, and so the price must fall in relation to new bonds in order to make the existing bond equally attractive. On the other hand, if interest rates fall, then new bonds will make lower income payments, and so the existing bonds with higher rates will look more attractive, forcing their prices up.
The vulnerability of bond prices to rising interest rates is usually referred to as interest-rate risk. One particular type of fixed-income security, the mortgage-backed bond, suffers especially from interest-rate risk.
The basics of mortgage-backed bonds
Mortgage-backed securities are bonds that have as their collateral the payments that homeowners make on their mortgages. The most popular issuer of these securities is Ginnie Mae, which is the nickname for the Government National Mortgage Association. Ginnie Mae bonds represent the final stage of a process in which mortgage loans are made to homeowners who qualify for one of a number of government programs, including the Federal Housing Authority, the Department of Veterans Affairs, the Rural Housing Service, and the Public and Indian Housing agency. Other issuers include Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE).
Essentially, when you buy a mortgage-backed bond, you're buying a small interest in the mortgages of a number of homeowners. Every month, those homeowners will make their mortgage payments, consisting of a certain amount of interest and a certain amount of principal repayment. Occasionally, one of the homeowners will decide to sell their home or to refinance their mortgage, at which point the original mortgage will be repaid in full. In turn, the payments you receive as income from your investment add together all of the small interest and principal payments from all the mortgages that act as collateral for your bond.
Heads I win, tails you lose
With mortgage-backed bonds, the main problem is that no matter which way interest rates move, you end up on the short end of the stick. As with other types of bonds, when interest rates rise, the value of your bonds will fall since they'll pay less interest than new bonds.
This would be fine if the value of mortgage-backed bonds went up when interest rates came down. However, when interest rates fall, homeowners tend to refinance their mortgages to take advantage of low rates to reduce their monthly payments. What that means for investors is that as more homeowners refinance their mortgages, the existing mortgages will be prepaid, and bondholders will receive larger payments of principal. Facing lower interest rates, investors have no choice but to take these principal payments and reinvest them in new bonds that will pay them lower amounts of income.
In some cases, mortgage-backed bonds will trade at prices that offer a higher yield than comparable traditional bonds. In financial jargon, this higher yield serves as compensation for the call option that the borrowing homeowners retain in the form of their ability to prepay their mortgages at any time. As an investor, it's important to realize that any additional yield you receive comes at the price of potentially finding yourself in a no-win situation regardless of which way interest rates move.
The best case for investors in mortgage-backed bonds is generally when interest rates stay within a relatively tight range over a fairly long period of time. Stable interest rates are helpful for mortgage-backed bonds because they tend to give homeowners little incentive to refinance their mortgages, and so any prepayments will generally occur for other reasons. If you succeed in getting an above-market interest rate for your bonds and interest rates don't change, then you may be able to simply keep the extra cash in your pocket.
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