There are many ways to invest your money and each offers its benefits and downsides. However, a smart investor can understand the many different investment avenues and utilize them in the best possible way.
Though real estate is a common investment asset, there are some related investments that are tied to the real estate market without requiring you to actually own any property at all. These include things like real estate funds, real estate investment trusts, and our topic for today: mortgage-backed securities (MBS).
Though mortgage-backed securities are often seen with some wariness by those who see them as connected to the 2008 real estate market collapse in the U.S., these securities are in fact a valid and safe investment instrument and a great way to gain exposure to the Canadian mortgage market. In particular, the Canadian banking system works much differently than the U.S., meaning you shouldn't feel too much trepidation when taking on mortgage-backed securities.
In this article, we will cover:
Security is essentially a financial instrument that represents some amount of financial value. In the case of stocks, for example, they represent ownership of a portion of a company and investors make money from the growth of the said company or other entity. These are referred to as equity securities, where the primary value to investors comes from eventually selling the security for a capital gain.
Mortgage-backed securities, on the other hand, are what is called debt securities – they represent a monetary debt and the eventual value to be repaid. It may seem strange that you can own debt, but that idea is fundamental to MBS. The holder of debt security makes money when the indebted party makes payments towards the debt’s interest.
First, you must understand that a bank always strives to keep its money in motion. So when you are issued a mortgage loan, for example, rather than be out of thousands of dollars, they now can sell the debt and continue to utilize their money elsewhere and that's exactly what lenders do: bundling mortgages to sell to third parties and other financial institutions.
Mortgage lenders bundle and sell mortgages because it lets them free up liquidity and keep mortgage rates and financing costs lower, while the third parties choose to purchase mortgage debt because they may sell portions of their bundled mortgages as mortgage-backed securities. This allows the average person to buy into mortgage-backed securities without having to purchase an entire mortgage or bundle of mortgages from a lender.
For these institutions who hold these mortgaged-backed securities, they make money from the interest on mortgages and the payment is ensured by the mortgage agreement that requires the borrower to pay back their loan.
Here is where the trouble started for the U.S. leading up to 2008. As many investment banks had bought a surplus amount of subprime mortgages, which began to fail as the housing bubble popped and many people defaulted on their loans, worsening the effects of the financial crisis that followed. These securities were suddenly worthless and many found they had lost mass sums of money as a result.
Canada had a much different story during the financial crisis which is due in large part to the more stringent lending practices of Canadian financial institutions, making mortgage-backed securities a considerably secure investment avenue.
In fact, in Canada, payments from mortgage-backed securities are guaranteed by the Canada Mortgage Housing Corporation CMHC (and by extension, the Canadian government). Furthermore, in order to further protect Canadian MBS from default, it is only loans that are insured against default, either by necessity or by the borrower's choice, that are eligible to be pooled for the purpose of an MBS. This, along with restrictions such as the mortgage stress test, make investing in Canadian mortgages very robust and secure, so long as the government has the ability to back up their guarantees.
Mortgage-backed securities first came to Canada in the mid-1980s with the National Housing Act Mortgage-Backed Securities Program (NHA MBS). This program outlines the rules and regulations of how mortgage-backed securities must function in Canada, as well as the extent to which the CMHC guaranteed payments for investors. The Canadian system was based upon U.S. practices, with some modifications for added security.
The Bank of Canada also offers what they call Canada Mortgage Bonds (CMB), a program that began in 2001. A CMB is similar to a standard MBS in that it derives its value from the repayment of mortgage debts. However, where a CMB differs is that it acts more like a traditional government bond. Rather than receiving regular payments of interest and principal, the holder of a CMB receives annual or semi-annual interest payments and receives the full principal value of the bond upon its maturity. CMB's are issued through the Canada Housing Trust, a trust set up specifically to buy mortgages and issue bonds and are also guaranteed by the CMHC.
Thanks to MBS, the average Canadian investor can easily begin to invest in mortgage markets. NHA MBS is available from multiple Canadian financial institutions like banks, insurance companies, credit unions, and others. NHA MBS can be purchased in increments of $5,000 and offer various term lengths ranging from one to 10 years.
During that term period, you will receive regular payments, usually monthly, until the term reaches its end, at which point you will have received your principal back and plus interest. In general, MBS will return about four to six percent of their value. In addition, an investor may sell their MBS at any time, though the market price of the security will decrease as it nears maturity.
Purchasing Canada Mortgage Bonds can similarly be done through your financial institutions.
The benefit of MBS is inherent to their security due to being backed by low-risk debt and secured by the CMHC. Because of that, an MBS is among the most low-risk investments Canadian investors can purchase. MBS can play a similar role in your investment strategy as you would use a bond or GIC. The downside is that the return is lower, as with most low-risk investments than the potential returns of more volatile assets like stocks.
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