Understanding Pass-Through Securities and Their Risks
Pass-Through Securities: Understanding and Risks
A pass-through security, also called a pay-through security or pass-through certificate, is a pool of fixed-income securities backed by a package of assets. A servicing intermediary collects monthly payments from issuers and passes them through to the holders of the security after deducting a fee. It is important to note that the certificate is evidence of interest or participation in a pool of assets, not the security itself.
Key Takeaways:
– A pass-through security represents a pool of fixed-income securities backed by various assets, such as home mortgages or car loans.
– A servicing intermediary collects monthly interest payments from issuers and funnels them to investors after deducting a fee.
– The most common type of pass-through is a mortgage-backed security (MBS).
– Risks associated with pass-throughs include defaulting on the underlying debt and early prepayment of loans.
Pass-Through Security Explained:
A pass-through security is a derivative based on debt receivables that gives investors a portion of the profits. The debt receivables are usually from underlying assets like mortgages or vehicle loans. Each security represents a large number of debts, such as multiple home mortgages or car loans.
Payments are made monthly, following standard schedules for debt repayment. They consist of accrued interest on the unpaid principal and a portion that goes towards the principal itself.
Risks of Pass-Through Securities:
The main risk is default on the associated debts, which can render the securities worthless. Additionally, changes in interest rates can affect returns. Lower interest rates may lead to refinancing and smaller interest payments, decreasing returns for investors. Prepayment by debtors can also impact returns, as it reduces interest accrued and may result in lower returns.
An Example of Pass-Through Securities:
The most common type is a mortgage-backed security (MBS). Homeowners’ payments pass through an intermediary before reaching investors. These securities derive their value from unpaid mortgages, with investors receiving payments based on partial claims to the payments made by debtors. Multiple mortgages are packaged together to spread risk across multiple loans. Generally, these securities are self-amortizing, meaning the mortgage principal is paid off over time with regular interest and principal payments.
