Most fixed income securities provide you with periodic interest payments over the stated term of the security and repay the principal in full at maturity. Most mortgage- and asset-backed securities, however, make both principal and interest payments monthly, quarterly, or semi-annually over the life of the security. Interest payments are fully taxable; principal payments are not.
- Most mortgage-backed securities are driven by the principal and interest payments on home mortgages. For example, a government-sponsored enterprise that provides housing loans, such as Fannie Mae, will issue a mortgage-backed security to generate capital for lending. The bondholders later receive their interest and principal in the form of monthly payments, as the mortgages that the funds were used to finance are paid off.
- Since homeowners have the right to pay off their mortgages at any time, these monthly payments may include additional payments of principal (known as prepayments).
- Generally, when interest rates decline, prepayments accelerate beyond the initial pricing assumptions, which could cause the average life and expected maturity of the securities to shorten. Conversely, when interest rates rise, prepayments slow down beyond the initial pricing assumptions, and could cause the average life and expected maturity of the securities to extend, and the market value to decline.
- When prepayments accelerate due to falling interest rates, principal may have to be reinvested at a lower interest rate than the coupon of the security.
- Similarly, many asset-backed securities are driven by consumer and home equity loans. For this reason, asset-backed securities structures always contain some form of credit enhancement to bring the credit quality to the desired level.
- In exchange for the cash flow uncertainty caused by prepayments, mortgage- and asset-backed securities afford you relative safety (provided you hold them to maturity), liquidity, and superior yields, relative to comparable bonds.
- Most mortgage- and asset-backed securities are available in small denominations, making them a good vehicle for diversifying your portfolio.