Pass-Through Securities: Definition, How They Work, and Real-World Examples
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Summary:
A pass-through security, also known as a pay-through security, is a type of fixed-income investment backed by a pool of assets, such as home mortgages or car loans. An intermediary collects payments from issuers, deducts a fee, and passes the payments to the investors. This article explores pass-through securities, their key characteristics, risks, and an example with a focus on mortgage-backed securities.
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Understanding pass-through securities
A pass-through security is a financial instrument that represents a pool of fixed-income assets, typically comprising a large number of debts, such as numerous home mortgages or car loans. Investors in these securities receive a share of the income generated from the underlying assets. The term “pass-through” refers to the process of collecting payments from issuers and passing them on to the investors.
How pass-through securities work
The process of pass-through securities involves a servicing intermediary who acts as a bridge between the issuer of the underlying debts and the investors in the securities. The intermediary collects monthly payments from the debtors, deducts a fee for its services, and funnels the remaining payments to the investors. These payments are typically made on a monthly basis and consist of accrued interest and a portion that goes towards reducing the principal debt.
Example of pass-through securities: Mortgage-backed securities
The most common type of pass-through securities is mortgage-backed securities (MBS). In an MBS, payments from homeowners pass through a series of entities before reaching investors. Here’s how it works:
- Homeowners make their mortgage payments to the original bank.
- These payments are then routed through a government agency or investment bank.
- Finally, the payments reach the investors who hold MBS.
Mortgage-backed securities derive their value from the unpaid mortgages, and investors receive payments based on their share of the debtors’ payments. Typically, MBS are created by packaging multiple mortgages into a pool, which spreads the risk across various loans. These securities are generally self-amortizing, meaning the entire mortgage principal is paid off over a specified period through regular interest and principal payments.
Frequently asked questions
What are the underlying assets in pass-through securities?
Pass-through securities can be backed by various underlying assets, but the most common type is mortgage-backed securities, which are supported by home mortgages. Other assets can include car loans and consumer debts.
How often are payments made to investors in pass-through securities?
Payments to investors in pass-through securities are typically made on a monthly basis, following the standard payment schedules for debt repayment.
What is the primary risk associated with pass-through securities?
The primary risk is the default on the underlying debts. If debtors fail to make their payments, it can result in lower returns for investors.
What is the difference between a pass-through security and a traditional bond?
A pass-through security is distinct from traditional bonds in that it represents a share of income from underlying assets, such as mortgages or loans. Traditional bonds, on the other hand, are a direct debt obligation with a fixed interest rate and maturity date. Pass-through securities provide a portion of the payments received from debtors, while traditional bonds pay periodic interest and return the principal at maturity.
How are pass-through securities affected by changes in interest rates?
Pass-through securities are sensitive to changes in interest rates. When interest rates fall, there is a higher likelihood of debtors refinancing their loans to benefit from lower rates. This results in lower interest payments to investors, impacting their returns. Conversely, rising interest rates can extend the duration of the securities as debtors are less likely to refinance, potentially increasing interest income for investors.
What types of underlying assets can back pass-through securities?
While mortgage-backed securities are the most common type of pass-through security, other underlying assets can include auto loans, student loans, and credit card debt. The choice of underlying assets depends on the issuer and the purpose of the pass-through security. Each type of asset comes with its own unique risk profile and characteristics.
How can investors mitigate the risks associated with pass-through securities?
Investors can employ several strategies to mitigate risks, including diversifying their portfolio of pass-through securities to spread risk across various assets. Additionally, conducting thorough due diligence on the quality of underlying assets and understanding the potential impact of changing interest rates can help investors make informed decisions. Some investors may also consider credit enhancements or insurance to protect against default risk.
Key takeaways
- Pass-through securities represent a share of income from a pool of fixed-income assets, such as home mortgages and car loans.
- An intermediary collects payments from debtors and passes them through to investors, providing a regular income stream.
- Risks associated with pass-through securities include the possibility of default on underlying debts, the impact of changing interest rates, and prepayments reducing returns.
- The most common type of pass-through security is mortgage-backed securities (MBS), where homeowners’ payments pass through intermediaries before reaching investors.
- Investors can diversify their portfolios, conduct due diligence, and consider strategies to mitigate risks when investing in pass-through securities.
- Pass-through securities may have tax implications, and it’s advisable to consult with a tax professional for guidance.
- While pass-through securities can offer regular income, they do not have a set maturity date and have an expected average life that can change over time.
- Retirees may find pass-through securities attractive for income, but they should be aware of potential risks and consider diversification in their investment strategy.
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