Mortgage-Backed Revenue Bond

What Is a Mortgage-Backed Revenue Bond?

A mortgage-backed revenue bond is a debt security, usually issued by a municipality, that is used to fund low-rate mortgages. The coupon payments of the bond come from the interest payments on the mortgages that the bonds are used to fund.

Understanding a Mortgage-Backed Revenue Bond

Mortgage-backed revenue bonds are issued to obtain funding for low-interest-rate mortgages. The mortgage payments collected from the funded loans provide the bond's coupon payments. In essence, the entity issuing the loan outsources mortgage funding to bondholders, who get paid a coupon based on the mortgage interest rate. Municipalities commonly issue these types of bonds through housing finance agencies (HFAs).

Mortgage-backed revenue bonds are similar to mortgage-backed securities. However, mortgage-backed revenue bonds are issued by municipalities, while mortgage-backed securities are issued by private entities or a government-sponsored enterprise (GSE).

Municipalities find mortgage-backed revenue bonds attractive because they provide social benefits within the community. By backing the issuance with low-interest-rate mortgages, municipalities can assist low-income first-time homebuyers who may not otherwise be able to afford the monthly payments associated with a standard mortgage.

Revenue Bonds

Revenue bonds generally refer to a subset of municipal bonds where the borrowed funds go toward a revenue-generating project or investment. The revenue generated from the investment, in turn, is used to pay back bondholders.

Because their repayments get tied to a specific income stream, revenue bonds carry greater risk than general obligation bonds, which municipalities repay through an array of sources, including tax revenue. In theory, that additional risk should generally provide investors with a better yield from a revenue bond versus a general obligation bond.

In the case of mortgage-backed revenue bonds, also known as housing bonds, the coupon payments that investors receive are typically exempt from taxes. This tax-advantaged treatment allows the bonds to remain attractive, despite returning lower interest rates in line with the mortgages that back them.

Bond proceeds could also go toward financing other types of real estate development, such as affordable rental housing. In those cases, the developer makes interest payments funded by the rent collected on the property.

Structuring a Mortgage-Backed Revenue Bond

Mortgage-backed revenue bonds are often created through a collaboration between Freddie Mac or Ginnie Mae and HFAs. The original lenders of the mortgages pool them into securities that are backed by Freddie Mac or Ginnie Mae. The securities are then sold to the housing finance agencies. It's important to note that the individual mortgages are not sold, just the securities.

These securities are then issued by state or local governments in conjunction with housing finance agencies.

Investing in a Mortgage-Backed Revenue Bond

As with any revenue bond, investors must take care to ensure they receive appropriate compensation for the risk they take. The potential for default on mortgage loans remains a risk in any bond backed by real estate, even when the loans go below market rate.

The quality of underwriting matters when investing in a mortgage-backed revenue bond. Likewise, the duration of the bond may vary. Most cover a short term, further reducing the default risk involved in any given issuance, and keeping interest rates relatively low.

The tax advantages provided by housing bonds can also offset the risks involved. From an investor’s standpoint, the value of tax-exempt interest derives from the actual amount of tax saved compared to a similar investment. Therefore, the value of tax-exempt interest rises alongside an investor’s marginal tax rate.