Mortgage-Backed Securities
A mortgage-backed security (MBS) is a bond backed by the mortgage payments of a pool of mortgages. From an investor’s perspective, an MBS is similar to any other kind of bond, except instead of receiving a fixed coupon payment, the investor receives monthly interest payments that vary depending on how quickly homeowners pay off their mortgages. That is, an investor who purchases a $1,000 mortgage-backed security will receive monthly interest payments that are based on the interest and principal payments of the underlying mortgages. In fact, the interest and principal payments from the mortgages are “passed through” to the MBS investor, and for this reason, they are known as a pass-through security. MBSs are also called pass-throughs or participation certificates.
Being a pass-through security means that if many homeowners choose to refinance or pay off their mortgages early, the MBS owner will receive larger interest payments than expected. Unfortunately, homeowners typically choose to refinance when interest rates fall, causing MBS investors to receive higher monthly payments when they can only reinvest the money at a lower interest rate. Thus, MBS owners are subject to prepayment risk (they get their money back sooner than expected, which may happen when interest rates fall) and extension risk (they get their money back slower than expect