Like mutual funds, “MBSs” have become very popular. These are interest-bearing instruments which are secured — or “backed” — by Canadian residential mortgages or social housing loans. MBSs come in two broad types — those insured by CMHC under the National Housing Act (“NHA”) and those not. The latter type may be secured by private financial institutions instead. If not, there is additional risk that the original principal may not be returned in full.

MBSs are further differentiated into pools of “prepayable” and “non-prepayable” mortgages (aka “open” and “closed“). The difference is self-evident if you yourself have ever shopped for a mortgage. With an open mortgage, you can opt to pay down the principal in lump sums over and above the regular amortization.

As underlying mortgages involve monthly blended payments of principal and interest by the borrower, so the receipts by the MBS investor include monthly interest and return of capital. With a closed MBS the return of capital is relatively predictable; however, with an open MBS, the unpredictable prepayments may cause unexpected returns of capital, which the investor must then re-place in other investments. Also, the unwary investor who spends the cash flow that comes into the MBS account each month may be surprised to learn later that he/she has been unwittingly “dipping into capital” for some time.

In an attempt to “meet the market”, a new MBS product has been tailored to satisfy
investors who want predictability of income stream. So-called “slow-pay” MBSs will pay monthly interest only, with the capital (generally) to be returned upon maturity. “Fast-pay” MBSs continue to pay monthly blended receipts of interest and principal. The latter is subject to the vagaries of principal prepayments.

A controversial topic for MBS investors has been the ownership of penalty interest payments. Again, as a mortgage borrower, you may have faced the issue of getting out of your existing mortgage and into a lower interest rate new mortgage. The deal usually includes the payment of penalty interest to restitute the mortgage holder for breaking the deal. Financial institutions are inter-placed between the mortgage borrower and the MBS investor. These MBS-issuing institutions are split over who should be entitled to the penalty interest. Thus, when you buy an MBS, you should ascertain the policy of the issuer. The MBSs issued by institutions which claim entitlement to the penalty interest cost less than those which pass the penalty on to the MBS investor.

MBSs are eligible investments for RRSPs and RRIFs.