Individual Bonds

Types of Mortgage-Backed Securities

Pass-Throughs

The most basic mortgage securities are known as pass-throughs. They are a mechanism—in the form of a trust—through which mortgage payments are collected and distributed (or passed through) to investors. The majority of pass-throughs have stated maturities of 30 years, 15 years and five years. While most are backed by fixed-rate mortgage loans, adjustable-rate mortgage loans (ARMs) and other loan mixtures are also pooled to create the securities. Because these securities "pass through" the principal payments received, the average life is much less than the stated maturity life, and varies depending upon the paydown experience of the pool of mortgages underlying the bond.

Collateralized Mortgage Obligations (CMOs)

Collateralized Mortgage Obligations, CMOs for short, are a complex type of pass-through security. Instead of passing along interest and principal cash flow to an investor from a generally like-featured pool of assets (for example, 30-year fixed mortgages at 5.5%, which happens in traditional pass-through securities), CMOs are made up of many pools of securities. In the CMO world these pools are referred to as tranches, or slices. There could be scores of tranches, and each one operates according to its own set of rules by which interest and principal gets distributed. If you are going to invest in CMOs—an arena generally reserved for sophisticated investors—be prepared to do a lot of homework and spend considerable time researching the type of CMO you are considering (there are dozens of different types), and the rules governing its income stream.

Many bond funds invest in CMOs on behalf of individual investors. To find out whether any of your funds invests in CMOs, and if so, how much, check your fund's prospectus or SAI under the headings "Investment Objectives" or "Investment Policies."

To recap, both pass-throughs and CMOs differ in a number of significant ways from traditional fixed-income bonds.

Mortgage-Backed Securities Risk Report Card Credit and default risk are real for MBSs issued by GSEs: The federal government is under no legal obligation to save a GSE from default. Prepayment risk that acts much like call risk: You get your principal back sooner than the stated maturity, but the reinvestment opportunities are limited due to the inconsistent prepayment rates, which are driven by real estate mortgage interest rates and refinancing trends; population, geographic mobility, and employment opportunities; and social and economic factors that are difficult to model. Extension risk: The opposite of prepayment risk—the risk that interest rates will go up, lengthening the estimated maturity (but not the stated maturity) of your MBS and creating more holding-period risk. Interest rate risk: If interest rates rise, the value of a mortgage-backed security on the secondary market will likely fall.

Mortgage-Backed Securities Snapshot Issuer Agencies of the federal government, GSEs and private financial organizations Minimum Investment Varies—generally $10,000 Interest Payment Generally paid monthly with payments varying each month How to Buy/Sell Through a broker Bond Interest Rate Determined at origination and varies by bond Price Information Issue price and secondary trade data available through a broker and data vendors Web Site for More Info SIFMA: What are Mortgage Securities?