A Comprehensive Guide to Pass-Through Securities and Their Associated Risks

Gordon Scott has been an active investor and technical analyst for over 20 years and holds the Chartered Market Technician (CMT) designation.

What Are Pass-Through Securities?

Pass-through securities represent a collection of fixed-income instruments backed by a diverse set of underlying assets. A servicing agent collects monthly payments from borrowers and, after deducting servicing fees, distributes these payments directly to the investors holding the pass-through securities.

Also referred to as "pay-through securities" or "pass-through certificates," these instruments provide investors with a proportional share of the cash flows generated by the underlying asset pool. It's important to note that the certificate acts as proof of ownership in the asset pool rather than being the security itself.

Key Insights

• Pass-through securities aggregate numerous debts such as hundreds of mortgages or thousands of auto loans into one investment vehicle.
• Monthly payments from borrowers are collected by an intermediary who deducts fees before passing the remainder to investors.
• Mortgage-backed securities (MBS) are the most prevalent type of pass-through securities.
• Investors face risks including borrower default and the impact of early loan prepayments.

How Pass-Through Securities Work

These securities derive their value from debt receivables linked to assets like home mortgages or vehicle loans. Each security represents a fractional ownership in a large pool of these debts.

The term "pass-through" highlights the flow of payments: borrower payments pass through an intermediary before reaching investors.

Investors receive monthly distributions that include interest accrued on the outstanding principal and a portion of the principal repayment itself.

$2.3 Trillion

This is the estimated total value of mortgage-backed securities assets as of mid-2024.

Risks Inherent in Pass-Through Securities

Default risk is a primary concern; if borrowers fail to make payments, investor returns decline, potentially causing the securities to lose value.

Interest rate fluctuations can also impact returns. Declining rates often lead to refinancing, which reduces interest payments and subsequently lowers investor income.

Prepayment risk arises when borrowers pay off loans early, diminishing the interest income investors receive. While some loans include prepayment penalties, these may only partially offset the loss in returns.

Example: Mortgage-Backed Securities

The most common pass-through security is the mortgage-backed security (MBS), where homeowners' mortgage payments flow from the original lender through government agencies or investment banks to investors.

These securities pool multiple mortgages to diversify risk and are typically self-amortizing, meaning they are structured to fully repay principal and interest over time.

How to Invest in Pass-Through Securities

Direct investment in pass-through securities like MBS is generally limited to institutional investors due to large minimum investment requirements. However, retail investors can gain exposure through mutual funds or exchange-traded funds (ETFs) that include pass-through securities in their portfolios.

Understanding the Pass-Through Rate

The pass-through rate is the net interest rate paid to investors after deducting servicing fees and expenses. A higher pass-through rate indicates that a larger share of the asset's income is passed on to investors.

Market Size of Mortgage-Backed Securities

As of August 2024, the U.S. mortgage-backed securities market held assets valued at approximately $2.3 trillion, reflecting its significant role in the financial system.

Final Thoughts

Pass-through securities provide investors with income streams derived from pooled asset payments, managed by intermediaries who deduct fees before distributing proceeds. Mortgage-backed securities exemplify this structure, offering diversified exposure to debt instruments but also carrying risks like default and prepayment.

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