Figure

Listing of corporate bond prices

Source: From The Wall Street Journal, October 19, 2001. Reprinted by permission of Dow Jones & Company, Inc. via Copyright Clearance Center, Inc. © 2001 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

Note that current yield ignores the difference between the price of a bond and its eventual value at maturity, and is a different measure than yield to maturity. The differences are explored in Part Three.

Mortgages and Mortgage-Backed Securities

Thirty years ago, your investments text probably would not have included a section on mortgage loans, for investors could not invest in these loans. Now, because of the explosion in mortgage-backed securities, almost anyone can invest in a portfolio of mortgage loans, and these securities have become a major component of the fixed-income market.

Until the 1970s, almost all home mortgages were written for a long term (15- to 30-year maturity), with a fixed interest rate over the life of the loan, and with equal, fixed monthly payments. These so-called conventional mortgages are still the most popular, but a diverse set of alternative mortgage designs have appeared.

Fixed-rate mortgages can create considerable difficulties for banks in years of increasing interest rates. Because banks commonly issue short-term liabilities (the deposits of their customers) and hold long-term assets, such as fixed-rate mortgages, they suffer losses when interest rates increase. The rates they pay on deposits increase, while their mortgage income remains fixed.

A response to this problem is the adjustable-rate mortgage. These mortgages require the borrower to pay an interest rate that varies with some measure of the current market interest rate. The interest rate, for example, might be set at two points above the current rate on one-year Treasury bills and might be adjusted once a year. Often, the maximum interest rate change within a year and over the life of the loan is limited. The adjustable-rate contract shifts the risk of fluctuations in interest rates from the bank to the borrower.

Because of the shifting of interest rate risk to their customers, lenders are willing to offer lower rates on adjustable-rate mortgages than on conventional fixed-rate mortgages. This has encouraged borrowers during periods of high interest rates, such as in the early 1980s. But as interest rates fall, conventional mortgages tend to regain popularity.

A mortgage-backed security is either an ownership claim in a pool of mortgages or an obligation that is secured by such a pool. These claims represent securitization of mortgage loans. Mortgage lenders originate loans and then sell packages of these loans in the secondary market. Specifically, they sell their claim to the cash inflows from the mortgages as those loans are paid off. The mortgage originator continues to service the loan, collecting principal and interest payments, and passes these payments along to the purchaser of the mortgage. For this reason, these mortgage-backed securities are called pass-throughs.

Mortgage-backed pass-through securities were introduced by the Government National Mortgage Association (GNMA, or Ginnie Mae) in 1970. GNMA pass-throughs carry a guarantee from the U.S. government that ensures timely payment of principal and interest, even if

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Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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