MBS alternative for income investors: mortgage backed securities provide attractive income streams. But there are some drawbacks

Money Digest, Oct, 1999 by Kerene Harvey

Investors seeking monthly income from their investments should take a look at Mortgage Backed Securities.

Mortgage Backed Securities, or MBS, originate when mortgages are pooled together and undivided interest in the pool is sold. In Canada MBS represent a pool of National Housing Association mortgages in which investors have an ownership interest. Each owner has a proportionate interest in the cash flows, generated by the pool. The cash flow consists of the monthly payments of principal, interest and in some cases prepayments.

MBS are underwritten by Canadian Mortgage and Housing Corporation (CMHC), a federal government agency, so they carry the same credit rating as the Government of Canada. MBS were first offered in Canada in 1986 and are issued by banks, trust companies and credit unions.

Like bonds, MBS trade over the counter and can be traded on any business day. But settlement only takes place on selected days each month. The term to maturity mirrors the terms of residential mortgages, with five years being the most common. Monthly payment of principal and interest is guaranteed by CMHC, regardless of whether or not payment has been received by the issuer of the mortgage.

There are two types of MBS. Open MBS represent a pool of open mortgages. These are prepayable mortgages, so future cash flows from these pools can be unpredictable. There is usually a yield premium attached to open mortgages to compensate for the possibility of early prepayment. Closed MBS cannot be prepaid, so the cash flow from this pool is more predictable.

Investors should remember, however, that each monthly payment consists of principal and interest. A portion of the original principal investment is being returned each month. Therefore, upon maturity or prepayment, the face value has been reduced by the principal payments.

MBS can usually be purchased in small denominations, and offer an attractive yield to maturity and a high degree of safety. The main disadvantages are that the term to maturity is short -- usually fewer than five years -- and MBS can only be traded on certain days of the month, so they are not the most liquid fixed income securities. Open mortgages can be prepaid early, and this option is exercised most often when rates are lower that the original mortgage rate, thereby forcing investors to look for other opportunities, usually at lower rates.

Kerene Harvey, CFA, is Associate Director and Portfolio Manager with Charles Schwab Canada. Phone: (416)