Mortgage-Backed Securities |
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Varied Monthly Interest Payments
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Varied Monthly Payments There's one more thing about those portions you've been getting—they are not the same each month. For this reason, investors who draw comfort from a dependable and consistent semiannual payment may find the unpredictability of mortgage-backed securities unsettling. |
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Unlike a traditional fixed-income bond, most MBS bondholders receive monthly—not semiannual—interest payments. There's a good reason for this. Homeowners (whose mortgages make up the underlying collateral for the MBS) pay their mortgages monthly, not twice a year. These mortgage payments are what ultimately find their way to MBS investors.
There's another difference between the proceeds investors get from mortgage-backed bonds and, say, a Treasury bond. The Treasury bond pays you interest only—and at the end of the bond's maturity, you get a lump-sum principal amount, say $1,000. But a mortgage-backed bond pays you interest AND principal. Your cash flow from the mortgage-backed security at the beginning is mostly from interest, but gradually more and more of your proceeds come from principal. Since you are receiving payments of both interest and principal, you don't get handed a lump-sum principal payment when your MBS matures. You've been getting it in portions every month.
MBS payments (cash flow) may not be the same each month because the original “pass-through” structure reflects the fact that homeowners themselves don’t pay the same amount each month. They often make unscheduled payments of principal, or prepayments. For this reason, MBS investors are subject to prepayment risk. The risk is highest when interest rates fall and homeowners refinance (prepay an existing mortgage). The resulting wave of prepayments means that there’s a greater chance that the MBS investor will be paid all of the interest and principal ahead of schedule.
There are advantages to this payment structure—namely, you have your money in hand—but the climate for reinvestment has deteriorated. Interest rates have declined and you can’t get the same return you had with your original bond. So be aware that refinancing booms can be a bust for MBS investors. At the same time, issuers increasingly apply statistical models to smooth out monthly payments. Also, the pass-through structure of aggregating large numbers of loans at a single fixed rate also helps keep cash flows relatively consistent. Since the mid 1980s, issuers have also offered a type of collateralized mortgage bond called planned amortization class, or PAC bonds, designed to reduce volatility associated with prepayments.
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