Mortgage-backed securities might sound tricky at first, but they're a vital part of the country's housing finance system. Canada's system is backed by government guarantees and strict regulations, making it a much more stable option for investors.
In this article, Wealth Professional Canada will help explain what mortgage-backed securities are, how they work, and whether you should recommend them to your clients.
Mortgage-backed securities (MBS) are investments made by grouping together individual residential mortgages and selling them to investors. In other words, it's a security backed by assets that are secured by mortgage or a collection of such.
Its basic concept is that a lender originates mortgages with homeowners, then packages a large pool of those mortgages and sells them as an investment product. When homeowners make their monthly mortgage payments, that money flows to investors who own pieces of the MBS.
This system creates several benefits. For lenders, it frees up capital so they can issue new mortgages. For investors, it provides a stream of income from mortgage payments without having to manage individual properties or borrowers.
Mortgage-backed securities (MBS) are investment instruments secured by pools of residential mortgage loans in Canada. When homeowners make their monthly mortgage payments, the principal and interest flow through to investors holding these securities.
Mortgage-backed securities are also a type of fixed-income instrument.
Think of it this way. Instead of a bank holding a mortgage for the entire 25-year life of the loan, they can sell it quickly to investors. This allows the bank to use that money to lend to the next homeowner who needs a mortgage. This cycle keeps credit flowing through the housing market and helps mortgage rates stay competitive for your clients.
When an investor buys an MBS, they're not lending money directly to a homeowner. Instead, they're buying the right to receive the principal and interest payments from thousands of mortgages in the pool. Because there are many mortgages bundled together, one homeowner's default doesn't impact the investor's returns as severely as it would if they owned a single mortgage.
There are three main types of MBS. Let's discuss them briefly:
With this type, lenders pool insured mortgages and investors receive a proportionate share of monthly payments. Your clients get predictable, steady income every month. The catch is that timing can vary when homeowners pay off their mortgages early or refinance.
These split a mortgage pool into multiple layers called tranches. Senior tranches get paid first and are safer but offer lower returns. Junior tranches are riskier but offer higher potential returns. This structure lets your clients choose a risk level that matches their portfolio goals.
This type divides mortgage payments into principal-only strips and interest-only strips. When interest rates fall and homeowners pay off mortgages early, principal-only strips gain value while interest-only strips lose value.
The Canada Mortgage and Housing Corporation (CMHC) guarantees the timely payment of principal and interest on most mortgage-backed securities.
This guarantee means that even if a homeowner stops paying their mortgage, the investor still receives their full payment on time. This also reduces the risk that comes with owning mortgages.
The National Housing Act Mortgage-Backed Securities program, which started in 1987, created the framework for this system. Lenders can pool insured mortgages and sell them to investors with the confidence that CMHC is standing behind those payments.
The Government of Canada also issues Canada Mortgage Bonds (CMB). These bonds work slightly differently than other MBS. Instead of receiving monthly payments, investors get semi-annual payments. This structure appeals to many institutional investors who prefer payments twice a year rather than every month.
Because of this government-backed system, Canadian mortgage-backed securities have remained stable and have not experienced the kind of defaults and losses that happened in the United States during the 2008 financial crisis.
The US market suffered because many mortgage-backed securities were based on subprime mortgages that lacked rigorous lending standards and weren't backed by government guarantees. So, when borrowers defaulted, investors lost enormous sums of money.
Canada's stricter approach prevented this from happening here.
In 2024, the government borrowed about $30 billion to buy mortgage-backed securities. They plan to spend another $30 billion in 2025 and onward in hopes of making hundreds of millions of dollars in profit.
They're making money by borrowing at a low interest rate and investing that money at a slightly higher interest rate. However, this strategy can be risky. Watch this video to find out why:
Yes. But whether mortgage-backed securities are right for your clients depends on what they're trying to accomplish with their money.
The main advantage of mortgage-backed securities is predictable income. Your clients get regular cash flows that they can count on. For investors who need steady income to cover living expenses, this is valuable. The income is also generally more stable than stock dividends, which can be cut if a company struggles.
Diversification is another major benefit. When your clients invest in an MBS, they're not betting on a single homeowner or a single property. They own a piece of thousands of mortgages. If one borrower defaults, it has very little impact on the overall returns. This spreading of risk across many borrowers is one of the things that makes MBS attractive.
The government backing in Canada is also a powerful advantage. Your clients are not taking on the credit risk of individual borrowers because CMHC guarantees the payments. This lowers the chance that your clients will lose money due to defaults.
Watch this short clip to better understand mortgage-backed securities:
Want to read more investment concepts? Feel free to check out our Glossary page!
A major drawback to mortgage-backed securities is prepayment risk. When interest rates fall, homeowners often refinance their mortgages to get a better rate. This means that they pay off their old mortgage early and take out a new one.
When this happens, investors in the old MBS get their principal back sooner than expected. That might sound good, but it's actually not. If rates fall, investors will have to reinvest that money at lower interest rates.
Interest rate risk is another consideration. When interest rates rise, the value of existing MBS falls because new MBS pay higher rates. If your clients need to sell their MBS before maturity, they might have to sell at a discount. This can reduce their returns.
Complexity is also worth mentioning. While pass-through securities are simple, collateralized mortgage obligations and stripped mortgage-backed securities require more analysis.
Your clients need to learn how the tranches work and how interest rate changes might affect different parts of the structure. This complexity means that MBS might not be suitable for every investor.
When your clients take out a mortgage, the lender doesn't always hold that mortgage for the entire term. Instead, the lender can package it with other mortgages and sell it as an MBS.
This allows the lender to recycle that capital and issue new mortgages to other borrowers. This continuous flow of capital keeps lenders competitive on rates.
The yields that investors demand for MBS also influence what lenders have to pay for funding. If investors want higher yields, lenders have to pay more to borrow through the MBS market. Those higher borrowing costs eventually get passed along to mortgage borrowers through higher mortgage rates.
In this way, MBS supports the smooth flow of mortgage credit through the Canadian economy. Without this system, there would be less capital available for mortgages, rates would be higher, and fewer people would be able to afford homes.
If your clients are interested in investing in mortgage-backed securities, there are two main ways to do it. The first is to buy National Housing Act Mortgage-Backed Securities directly from financial institutions. Banks, trust companies, and credit unions all offer NHA MBS to investors.
The second way is to purchase Canada Mortgage Bonds (CMB). These bonds work similarly to MBS but offer semi-annual payments instead of monthly payments. They also have fixed mortgage terms of up to 10 years, making them easier for investors to plan around.
For investors who want a steady income and are comfortable with the risks of interest rate changes and prepayment, MBS can be an attractive option. They provide government-backed security and regular cash flows across thousands of mortgages.
The stability of Canada's mortgage-backed securities market, combined with CMHC guarantees, means that your clients can invest their money in a safe structure. This doesn't mean that there's no risk, but it does mean the risks are well-understood and backed by the Canadian government.
Overall, being knowledgeable about MBS can help you guide your clients better in building personalized portfolios that align with their needs and objectives.
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