Federally Backed Mortgage Notes

Conservative investors desiring retirement income can do better than many other alternatives by investing in federally guaranteed and federally backed mortgage notes. The notes issued by Ginnie Mae, Freddie Mac and Fannie Mae often provide yields 1% to 1.5% better than Treasury notes. And for investors willing to make the required trade-off, explained below, the extra income can be welcome.

Mortgage notes have an implied AAA rating. Therefore, the credit markets do not consider them to have more credit risk than treasury securities. But while treasury securities have a fixed maturity date, mortgage notes do not. And you get a higher yield for accepting that variability.

When you invest in mortgage notes, you are lending your money to a group of people to buy homes (with the federal agency or federally sponsored corporation guaranteeing your money). So don't worry if these people don't pay their mortgage, get foreclosed on and the house gets sold at a loss, you will still get your money.

However, if the borrowers move and pay off their mortgage or refinance, you get paid back. This could happen at any time. You could get payments or principal at any time. For many seniors, this is not a big negative because the return of their principal is of utmost importance, which is assured if you hold the notes to maturity (various maturity options are readily available). But, if you invest say in a mortgage pool that pays you 5% and all of the people in that pool refinance their mortgages at 3.5% you will get paid back early and have no alternative than to reinvest at lower rates. had you purchased treasury securities, you would have received less than 5% but your rate would have been fixed for the entire term. That's why mortgage securities pay more--you can get paid back at any time and the higher rate compensates you, the investor, for that "prepayment risk."

Many large brokerage firms have a solution to the above problem. They will buy the mortgage securities and split those securities into two parts: the part that pays the interest and the part that pays the principal. You can purchase just the part that pays the interest and not need to worry about having your principal returned. (Other people will purchase the more variable principal portion and receive higher interest for taking all of the prepayment risk). Be aware that these are securities of the brokerage company not of the government guaranteed entity. However, my opinion is that these are no less secure in practicality as they are backed by the original guaranteed security.

If extra retirement income is desired without sacrifice of credit quality, ask your financial professional about federally backed mortgage notes. Buy individual notes and not a mutual fund for reasons we cover in this post.

(Note that with mortgage securities, the yield and average life consider prepayment assumptions that may or may not be met. Changes in payments may significantly affect yield and average life. Both treasury securities and mortgage notes have a fixed percentage yield and treasury securities have a fixed maturity).