What are Pass-Through Securities?

Pass-through securities are one of the widely used financial instruments. Several mortgages may form the pool for a mortgage pass-through security, and different types of mortgages can be used in this securities mortgage. These securitized are then passed through to another party willing to make payments against it. The pass-through security investors receive the monthly cash flows generated by the underlying pool of mortgages, less any servicing and guarantee/insurance fees.

Why are Pass-Through Securities important?

The most crucial characteristic of pass-through securities is their prepayment risk; because the mortgages used as collateral for the pass-through can be prepaid, the pass-throughs themselves have significant prepayment risk. Hence, investors should know about this product to manage their risk well.

Pass-through securities also offer several benefits to investors. One of the primary advantages is their high liquidity, as they are traded actively in the secondary market. Moreover, these can offer higher yields than other traditional fixed-income securities due to their prepayment risk. They also provide diversification benefits to investors by allowing them to invest in a pool of underlying mortgages rather than a single mortgage. This diversification can reduce the overall risk in an investor’s portfolio.

Furthermore, pass-through securities can be tailored to meet specific investment objectives, such as providing regular income or capital appreciation. For example, investors seeking regular income can invest in this that pays out monthly, while investors seeking capital appreciation can invest with longer maturities or higher coupon rates.

This is also crucial in the mortgage market, as they allow mortgage lenders to free up capital to make new loans. By selling pools of mortgages to investors, lenders can reduce their risk exposure and generate more funds to make new loans, which ultimately stimulates economic growth.

Additionally, pass-through securities have some unique features that can make them attractive to investors. For instance, pass-through can offer a higher yield compared to other fixed-income security with similar maturities due to the prepayment risk. This is because the higher the prepayment rate, the shorter the maturity of the pass-through security, and the higher its yield.

Furthermore, pass-through securities can be an effective way for mortgage originators to free up capital for new loans. By pooling their existing mortgage loans and selling them as pass-through security, mortgage originators can access a new source of funding and deploy the capital for new loans. This, in turn, can boost mortgage origination and increase the availability of mortgage credit in the market.

Overall, pass-through security plays an essential role in the mortgage market and offers benefits to both investors and mortgage originators. However, it’s crucial for investors to understand the prepayment risk associated with this security and to carefully evaluate them before investing.