Bond Basics – Understanding Mortgage-Backed Securities, Zero Coupon, High Yield Money Market, and Callable Bonds

Written by: John Landers

Mortgage Backed Securities

Government-sponsored enterprises (GSEs)—Fannie Mae, Ginnie Mae and Freddie Mac issue mortgage-backed securities (MBSs) – mortgages packed as investments and sold to institutional investors and wealthy individuals. MBSs provide funding for the mortgage industry. Debt securities issued by GSEs have a higher coupon than high-grade corporate bonds.

If you purchase MBSs, understand that in a vibrant mortgage refinance market, homeowners pay off their mortgages, which reduces the life of the investment and the yield received by bond owners. Another risk concerns borrower’s default of mortgages. Investors must pay taxes on mortgage-backed securities. Banks and other private companies also package mortgages and sell them as mortgage-backed securities.

Zero Coupon Bonds

Zero coupon or discount bonds do not pay interest. Zero coupon bonds include U.S. savings bonds, U.S. Treasury bills and long-term zero coupon bonds. Investors purchase zero coupon bonds at a significant discount from the face value. Instead of earning periodic interest payments, when the bond matures, investors receive a lump sum payment. The single payment includes the principal plus a coupon based on the promised interest rate compounded semiannually.

Money Market

Most individuals invest in bonds through the purchase of shares in bond money market funds. Money market funds provide a vehicle for saving money over a short period to accumulate a down payment for a home, vehicle or other large purchase. Investors also use money market funds to park money for future investments. Money market funds do not provide a high return, but investors can withdraw funds as needed.

Bond Funds – This instrument offers investors a vehicle for portfolio diversification. Treasury bond funds consist of U.S. Treasury bonds. Some bond funds encompass municipal bonds or corporate debt securities. Bond funds do not have fixed maturity dates. In addition, the yield fluctuates. Investors pay for annual cost, which reduces the yield, but can withdraw the money at any time. Investors considering the purchase of a bond fund need to review for low annual expenses before making a decision.

High-Yield Bonds

Some corporations do not have the necessary credit ratings to qualify their bond offerings as “investment–grade,”  according to credit-rating agencies like Fitch Ratings, Standard & Poors and Moody Investor Services. High-yield corporate bonds carry greater financial risks, including:

1.     Falling bond prices during economic downturns

2.     Possible default of the issuer

3.     Bond price decline because of lowered credit ratings

4.     Bond price rating due to unexpected financial news or events

5.     Difficulty locating a buyer in the secondary bond market

In return for increased risks, issuers, which include U.S. and foreign corporations, U.S. banks and foreign  governments, pay higher interest rates to attract more investors.

Callable Bonds

A callable bond enables issuers to “call” bonds—stop making interest payments and repay the principal early—usually after a few years, at a specified price. In return for the risk of recallable bonds, issuers pay investors higher yields than noncallable bonds. Issuers repay callable bonds to save money on interest payments. If you want to reinvest your capital in similar bonds, you will have to accept interest rates at lower levels than when you  invested in the callable bond.


Bond Basics – Understanding Mortgage-Backed...

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