Mortgage-backed securities (MBS) is a debt obligation representing claims to the cash flows from bundles of mortgages. Most common on a residential property, most MBS are pass-through securities, which means the principal and interest payments every month pass through the issuer to the investor. Having about $9 trillion outstanding, these securities are one of the largest components of the US bond market.

In the United States, most MBS come from the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Government National Mortgage Association (Ginnie Mae). Others are issued by brokerage firms, banks, home builders, and other private entities.

Securities from Ginnie Mae are considered the safest since the US government backs its financial obligations, full faith and credit. However, those sold by Fannie Mae and Freddie Mac do not enjoy the same degree of protection because both are not supported by the US government although they possess special authority to borrow from the US Treasury.

Both Fannie Mae and Freddie Mac only securitize traditional loans adhering to its relatively old school guidelines. The federal government insures or guarantees mortgages from Ginnie Mae, including loans from the Federal Housing Administration and Veterans Affairs.

The Financial Crisis in 2008

The creation of MBS completely revolutionized the housing industry, as well as banking and mortgage business. It is a widely held belief home prices won’t plummet – that belief made consumers incorporate home purchase as the foundation of their financial plans.

Also, speculators used this rationale to generate profit from "flipping". Values of houses have dramatically escalated during the early parts of the 21st century. As a result, many people started to stipulate home values won’t only decline, but it would also continue to increase indefinitely.

Unfortunately, that belief was proven otherwise. Between 2006 and 2008, home prices began to plunge. The rates were not seen since the Great Depression. And as the housing market collapsed, several investors who held such instruments sustained huge losses.

Investing in Mortgage-Backed Securities

With ETFs, it is way easier to enter the mortgage-based bond market, which can complement other fixed-income investments. MBS also have a little distinct risk/reward profile compared with other instruments. It can give moderately greater yield, but at the expense of prepayment risk. For instance, an investor decides to purchase a security backed by 30-year mortgages, interest rates can drop and homeowners will seek refinancing. The investor retakes their principal early and needs to reinvest it in securities with a lower yield, making it difficult to determine the actual yield-to-maturity for MBS, which is why they trade at a spread above Treasury yields.

Investing in such securities through an ETF offers certain definite advantages. Normally, purchasing a MBS directly from the issuer will require at least a $10,000 commitment. With exchange-traded funds, a portfolio may be exposed to these securities with a much smaller capital outlay.

But before investing in MBS, do a research about the investment company. An investor may want to know the following: Source of underlying loans, fees charged by the fund, and its weighted average life.