A red-hot housing market is enabling banks to sell a new kind of bond that shares the risk of mortgage and loan defaults with institutional investors.

Texas Capital Bank recently sold $275 million of securities to investors looking to cash in on the pandemic-fueled boom in home prices. The bonds are backed by short-term loans the bank makes to mortgage lenders. When those lenders’ borrowers default, the investors in the bonds effectively cover the loss.

The transfers are a product of the effort to shield Fannie Mae and Freddie Mac from the risk of a mortgage-market reversal. Banks are now using them to raise capital and otherwise shore up their balance sheets, a process that ultimately adds to their lending capacity, analysts said.

Banks including JPMorgan Chase & Co. and Citigroup Inc. have recently increased sales of risk-transfer securities tied to mortgages, auto loans and corporate debt. However, the entry of regional banks marks a new phase in the market’s expansion, said Simon Boughey, an analyst at Structured Credit Investor.

“The addition of Texas Capital Bank to the roster in March this year shows there is potential for this mechanism to grow,” said Mr. Boughey.

SHARE YOUR THOUGHTS

What is your outlook on credit-risk transfers? Join the conversation below.

While the risk transfers revive memories of the financial products that boomed before the financial crisis, investors said they remain a niche product, supported by a surging housing market and a recovery that has improved borrowers’ credit quality.

Investors lose if the underlying loans default but receive relatively high yields in return. The average yield that investors demand to hold the riskiest version of the investment is more than 5%. That compares with 1.89% for the 30-year U.S. Treasury and around 4% for corporate bonds, according to data from Intercontinental Exchange.

The average yield on mortgage-backed securities was 1.36% as of July 22, according to an ICE Bank of America index. That compares with nearly 2.4% in February 2020.

“People want exposure to housing and consumer markets that are performing,” said Kaustub Samant, a securities analyst at JPMorgan. “Risk transfer securities are one of the few places that give high returns in this environment.”

Meanwhile, a housing shortage, coupled with surging demand from Americans fleeing cities or buying bigger homes, drove U.S. home prices to their biggest annual increase in more than two decades in May.

Related Video

As rental-home investors around the U.S. snap up single-family houses, some investors are buying homes through sale-leaseback transactions, which offer struggling homeowners a way to pay off debt while staying in their home. But many experts worry they may never be homeowners again. The Wall Street Journal Interactive Edition

That has pushed up the value of real estate occupied by owners to $34 trillion as of the end of the first quarter of 2021, according to data provider CoreLogic Inc. Nearly $1 trillion of those gains took place in the first three months of the year.

Ryan Osborn, a bond manager at Columbia Threadneedle Investments, said he held a limited amount of credit-risk transfers backed by Fannie and Freddie over the past few years but bought more after the market selloff last year.

“That changed significantly after March of 2020,” said Mr. Osborn. “Not only did valuations become considerably more attractive but the fundamental story around housing and interest rates changed.”

While investors often turn to conventional mortgage-backed securities to make bets on the housing market, central-bank policy has squeezed returns. The Federal Reserve’s efforts to boost the economy through the pandemic include buying $40 billion worth of mortgage bonds each month, alongside $80 billion of Treasury debt.

While hedge funds were among the earliest buyers of credit-risk transfers, conventional asset managers are also adding to their positions. Prices fell when the pandemic roiled markets, attracting bargain-hunters. Fannie Mae also curtailed issuance, leaving more investors chasing fewer securities.

Jason Smith, a portfolio manager in global securitized products at Neuberger Berman, said his funds have added credit-risk transfers from Fannie and Freddie, betting on growth to raise housing prices and borrowers’ credit quality.

“We have consistently been involved in the product, but this year presented an outsized opportunity,” he said.

Write to Julia-Ambra Verlaine at Julia.Verlaine@wsj.com