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Course 203
Collateralized Mortgage Obligations

Introduction

Mortgage-backed securities, or pass-throughs as they are sometimes called, provide an investment that has the security of bonds but with a higher yield. Unlike bonds, however, you never know when the home mortgages that back pass-throughs might be prepaid, introducing a note of uncertainty to your investment. Collateralized mortgage obligations, or CMOs, are mortgage-backed instruments that make the term of your investment more reliable.

What Are Collateralized Mortgage Obligations?

The "mortgage" in collateralized mortgage obligation (CMO) refers to the home mortgages on which these securities are based. Like other mortgage-backed securities--Ginnie Maes, Freddie Macs, and the like--CMOs are based on the performance of home mortgage loans that are sold by their lenders to an intermediary company. This company packages the loans as certificates that investors can buy. The interest and principal payments on the mortgages go from the homebuyer through the intermediary and then to the investor--which is why they are called pass-through securities.

With other kinds of pass-throughs, the performance of your investment depends on how and when the homebuyer pays the mortgage. CMOs are fundamentally different in that they are based not on one mortgage but on a pool of loans that are categorized based on the payment period of the mortgages in the pool. In this way, CMOs seek to limit the uncertainty that can be caused when mortgages are prepaid--a problem for pass-through investors when declining interest rates lead many people to refinance their home loans. They also spread the risk of default among a number of investors.

The mortgage pools that underlie CMOs are divided into categories called tranches based on the repayment schedules of the mortgages. Bonds are then issued on each of the tranches, each with a differing maturity date and interest rate. CMO bonds are issued with maturities of 2, 5, 10, and 20 years. Coupon payments from the mortgage pool are paid to the bondholders for each tranche while principal payments are applied first to the bonds with the shortest maturity (the first tranche).

CMO bonds are highly rated; because they are often based on government-backed mortgages and other top-grade loans, there is little default risk involved.

CMO bonds are issued by the Federal Home Loan Mortgage Corporation (FHLMC), the federally sponsored corporation that also issues Freddie Mac pass-throughs. CMOs are also issued by other government-sponsored agencies as well as private issuers. Some investors hold CMO bonds to maturity; they can also be sold and bought on the secondary market, where their prices fluctuate with changes in interest rates.

Companion Bonds and PACs

Collateralized mortgage obligations may issue special classes of bonds that can either increase or decrease the risks involved in CMO bonds, allowing investors to opt for increased security or the potential of higher returns.

Companion bonds are a special class of CMO bond that is paid off first when the underlying mortgages in a CMO pool are prepaid. Prepayments tend to occur when interest rates fall, so the payment rate on the companion bonds varies with interest rates. As a result, companion bonds absorb much of the prepayment risk in the CMO and display greater volatility on the secondary market. The potential of higher yields is the investor's reward for taking on these risks.

On the other hand, planned amortization class bonds, or PACs, work to reduce risks for investors. Some of the income from the mortgage pools that underlie PACs is diverted into a sinking fund--a special account used to help pay off the PACs. The availability of this sinking fund makes it more likely that the bonds will perform as expected, except in cases of extreme prepayment situations. In return for lower prepayment risk, PACs tend to pay lower interest rates than other classes of CMO bonds.

Strategic Considerations for Collateralized Mortgage Obligations

The main advantage that collateralized mortgage obligations offer over other kinds of mortgage-backed pass-through securities is protection from the prepayment uncertainties caused by changing interest rates. With Ginnie Mae and Freddie Mac bonds, a drop in interest rates could cause the mortgage you bought to be paid off early, shortening the term of your investment and diminishing your overall yield. CMOs offer a degree of protection that makes the income they produce more reliable than returns from other pass-throughs. This protection is not iron-clad, however. Even a relatively low-risk PAC bond might suffer in the event that plunging interest rates cause a rush of mortgage prepayments.

CMO bonds typically receive AAA ratings, largely because they are based mostly on government-backed mortgages. Another advantage CMOs offer investors is a lower minimum cost to buy into the investment. It is possible to buy a CMO bond for as little as $1,000, compared with a $25,000 minimum for other newly issued pass-through securities.

Because of their relative safety from mortgage prepayment, CMOs tend to offer lower yields than other pass-through securities. However, they still tend to perform better than other kinds of fixed-income securities such as U.S. Treasury bonds. And default risk is low: CMO bonds typically receive AAA ratings, largely because they are based mostly on government-backed mortgages.

While returns from CMOs are taxed as regular income, it is possible to include these instruments in tax-deferred retirement accounts. Also, as with most fixed-income securities, CMOs offer little protection against the detrimental effects of inflation.

Are They For You?

Collateralized mortgage obligations are bonds based on pools of home mortgages arranged to minimize the impact of loan prepayments on investment returns. Special classes of CMO bonds, such as companion bonds and PACs, either increase or decrease the prepayment risk--and the risk premium--for investors. While CMO bonds tend to pay lower yields than other pass-through securities, they still tend to outperform other kinds of low-risk debt securities such as U.S. Treasury bonds.

Quiz 203
There is only one correct answer to each question.

1 CMOs divide mortgages into tranches on what basis?
a. The repayment schedule
b. Interest rates
c. Maturity date
2 Which bonds pay higher returns for accepting higher prepayment risk?
a. CMOs
b. PACs
c. Companion bonds
3 Which bonds feature lower prepayment risk and offer lower returns?
a. CMOs
b. PACs
c. Companion bonds
4 Which is an investment benefit of CMOs?
a. Low tax rates
b. Higher yields than those of other pass-throughs
c. Higher yields than those of U.S. Treasury bonds
5 Which is not an investment benefit of CMOs?
a. Low tax rates
b. Low prepayment risk
c. Low default risk
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