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 The
Money Management Newsletter: Choosing
Financial Services
Mortgage Backed Securities... Look before you
leap
By Rob Whipp
Money Management Newsletter - Dec. 1994
Before jumping into a Mortgage Backed Security (MBS)
there are a few details that should be understood so that an informed
decision can be made on what is being purchased. Some of these are noted
below.
Certificate amount
The principal amount of the certificate when the MBS was first issued
(denominated in multiples of $5,000.00). Each month due to payments and
possible prepayments on the MBS the outstanding principal declines although
any certificate issued still shows the original certificate amount.
Coupon
The original investment rate attached to the MBS pool. The coupon
determines the income stream or cashflow for the investor.
Payments
Income flow from an MBS is always monthly and is disbursed to holders
on the 15th of the month but may be as late as the 18th allowing for long
weekends. Payments come from the "pool" of mortgages which make
up the particular MBS and include interest income up to the previous month
end and a portion of principal. Since some principal is returned
each month the dollar amount at maturity will be less than you started
with. Payments can be received by cheque or deposited directly to a bank
account.
Prepayments
There are two different types of MBSs: Prepayable or "open"
and Non-prepayable or "closed". Individuals invested in "open
pools" can expect to receive lump sums of their principal back at
various times as mortgagors in the pool take advantage of prepayment privileges.
Any re-investment of these lump sums will have to be at prevailing market
rates. Investors will also find that subsequent monthly payments on the
MBS are smaller since interest is then earned on a lower principal balance.
With "closed pools" mortgagors
are not allowed prepayments and thus no lump sums of principal are received.
Monthly payments therefore stay pretty much constant.
Yield
MBSs quote a yield
which is not the same thing as an interest
rate. An MBS yield assumes that the monthly payments received are re-invested
at the same rate as the original investment and the total projected income
is used to arrive at a yield. While the coupon
determines the cashflow of the pool, this cashflow will be translated
into a yield that reflects market conditions possibly by way of a premium
or discount
to the investor (see below). Yields that influenced by the characteristics
of the individual pool as well as market conditions. For example, "open
pools" offer a higher yield that "closed pools" as investors
are compensated for the possible negative implications of unscheduled
prepayments. (Note: "open pools" purchased at a premium will
end up with a reduced yield if the pool prepays quickly and an improved
yield if the quick paying pool is purchased at a discount.) High premium
pools may also provide a yield enhancement to compensate for tax implications
(see below).
Premium or discount
High coupon pools with their high cashflows will have greater value
in a period of low interest rates. Investors will however have to pay
more than the outstanding principal for these certificates and thus pay
a premium. Paying a premium brings the yield in line with existing market
rates. Alternatively low coupon pools with low cashflows will not be worth
as much in a time of high interest rates. Investors will then pay less
than the outstanding principal for these certificates or a "discount".
Tax considerations
Individuals in high tax brackets should check with their accountants
or tax advisors before buying a pool that has a high premium attached
to it. The high premium means the pool has a high coupon and cashflow
relative to the yield. The investor pays tax at his marginal
tax rate on the cashflow received, irrespective of the yield, and
the premium paid will translate into a capital
loss. If however, the investor will not have any taxable capital
gains to offset by the capital loss there may not be much advantage
in paying the premium for the high cashflow.
Example:
Assume that current market rates for a one year investment are 7%
and there are two investment choices available for an investor
in a 50% tax bracket. Investment "A" is a $10,000.00
one year bond with a coupon of 10%. Investment "B" is a $10,000.00
one year bond with a coupon of 7%. Investment "A" has a premium
of $280 to bring its yield down to market rates of 7%. (Note: we used
a bond for simplicity although the implications are the same for an MBS).
Actual dollar returns are as follows:
| "A" | "B" | | Certificate amount | $10,000.00 | $10,000.00 | | Coupon | 10% | 7% | | Premium paid | $280.00 | Nil | | Annual cashflow | $1,000.00 | $700.00 | | Less tax at 50% | $500.00 | $350.00 | | After tax income | $500.00 | $350.00 | | Less premium paid | $280.00 | Nil | | Actual return | $220.00 | $350.00 |
While both investments had a yield of 7% the investment
purchased at a premium had a $130.00 after tax disadvantage at a 50% tax
rate. The difference however will be less at lower tax rates. There may
be a yield enhancement offered for the premium product however it would
have to be substantial for someone with a high marginal tax rate.
It is important to know the particulars of any MBS before
purchasing as there is more to consider than just yield. Investors should
first select the type of pool (open closed) that suits them. They should
then consider the after tax effects of paying a premium or discount taking
into account any yield enhancements offered.
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