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What are mortgage-backed securities?

Mortgage-backed securities have been described as one of Canada's best-kept investment secrets. A mortgage-backed security is a low-risk, fixed income investment. These securities represent a pool of residential mortgages issued by banks and other lenders, and insured by Canada Mortgage and Housing Corporation (CMHC), a federal agency. Many of the mortgages pooled originate from people who don't have the minimum down payment for a home and therefore require mortgage insurance under the National Housing Act (NHA).

Mortgage-backed securities are usually purchased through an investment broker but banks, trust companies and other financial institutions offer them as well. When you purchase a mortgage-backed security, it is in the form of a certificate, referred to as a unit, that the investment dealer usually holds in safekeeping. If you've ever purchased a Canadian Savings Bond, a mortgage-backed security is a similar physical certificate with a fixed yield rate and maturity date. NHA mortgage-backed securities are considered attractive investments because they are insured by Canada Mortgage and Housing Corp. and come with a government-backed guarantee of payment of principal and interest.

How do mortgage-backed securities work?

You buy and sell mortgage-backed securities like bonds, at prices that include a commission on the transaction. Because they are interest rate sensitive, they tend to come in and out of vogue depending on the prevailing level of interest rates. Current rates for mortgage-backed securities can be obtained through your investment advisor or are quoted in the National Post FP Investing section, and in The Globe and Mail Report on Business.

After you purchase a mortgage-backed security (minimum purchase $5,000), you receive, on the 15th of every month, a payment from the issuer that represents a blend of interest (at the rate promised) plus a share of principal from the borrowers. What makes this investment so attractive is the guarantee: you receive your monthly payment of interest and principal even if some or all of the borrowers fail to make payments.

When your $5,000 unit eventually matures, you will not receive $5,000. Instead you, will receive the amount, less the principal you have already received.

Minimum Investment Required

Available in $5,000 units.

Term

  • Mortgage-backed securities are usually issued with a five-year term but shorter terms are also available.

Yield

  • Their yield ranges from 20 to 30 basis points above a Government of Canada bond (a basis point is 1/100th of a percentage point).

Tax Considerations

  • Income tax is payable on the interest portion of your monthly payments.
  • Investors are provided with appropriate records for income tax purposes.

Key Features

  • Guarantee: Mortgage-backed securities created with NHA-insured mortgages (known as NHA MBS) are fully guaranteed by the Government of Canada through CMHC.
  • Comparable Returns: Investment returns are comparable to GICs and higher than Government of Canada bonds.
  • Liquidity: An active secondary market, means mortgage-backed securities can be sold readily. You ask your broker to sell them at the going price, like a bond. Keep in mind that the price depends on what has happened to interest rates since you invested in the securities. Similar to Government of Canada bonds, if rates have gone up, you will receive less than you invested. On the other hand, if interest rates have gone down, you should get more than you originally paid. However, how much you receive also depends on how much principal has been repaid.
  • Timely Cash Flow: Monthly payments to investors can be made by cheque or by direct deposit into a financial account of your choice.
  • Affordability: Denominations of multiples of $5,000 are attractive for many investors.

Tips on Investing in Mortgage-backed Securities

  • Mortgage-backed securities can usually be held within registered retirement savings plans (but check the information circular for the particular mortgage-backed security).
  • Instead of spending the principal you receive each month, put it to work by reinvesting the amount received.
  • Prices and respective yields reflect the current interest rates available in the market place; as with bonds, prices for mortgage-backed securities tend to go down as interest rates rise and tend to go up when interest rates fall.
  • All mortgage-backed securities are not created equal. This article describes mortgage-backed securities guaranteed by the Government of Canada through CMHC. Financial institutions may offer second and third mortgages that are not guaranteed and may involve risk.

What type of investor is suited to mortgage-backed securities?

  • Investors who seek a secure source of regular income.
  • Large, pension-fund investors seeking comparable yields and cash flow for pensioners.

Other Sources of Information on Mortgage-backed securities

For investors wishing more information on mortgage-backed securities, Canada Mortgage and Housing Corporation offers an excellent web site at: www.cmhc-schl.gc.ca. Specialists who issue mortgage-backed securities at banks, trust and insurance companies, loan companies, credit unions and caisses populaires, can be contacted.