What Are Mortgage-Backed Securities and How To Invest In Them?

What Are Mortgage-Backed Securities and How To Invest In Them?

You have probably heard the term ‘mortgage-backed security’ and might associate these types of securities with the 2008 financial crisis. But what are they exactly and how do they work?

Firstly, it is important to understand that mortgage-backed securities have long been viewed as some of the most stable and reliable financial instruments on the market. People buy homes all the time and a vast majority of them need a mortgage to finance the purchase of the property of their choice. 

Mortgage-backed securities, or MBS for short, are financial instruments that are created by pooling together a large number of individual home mortgages and then selling interests in the pool to investors. Typically, these investors are major financial institutions, such as banks, pension funds, and asset management companies. However, individual investors can also invest in them. 

"What the mortgage bubble was all about was big banks like Goldman Sachs taking big bundles of subprime mortgages that were lent out largely to low-income, highly risky borrowers, and applying this kind of magic-pixie-dust math to these bundles of securities and slapping AAA ratings on them." - Matt Taibbi

The way mortgage-backed securities generate cash flows is by the interest and principal paid by the home buyers. 

If you are a somewhat conservative investor and would like to invest some of your money in mortgage-backed securities - look no further than this investfox guide on MBS-s. 

How Do Mortgage-Backed Securities Work?

Before we dive into some more details, we must first understand the basic principles behind mortgage-backed securities - what they are and how they work. The way MBS-s are created and marketed can be broken down into five key steps:

  1. A mortgage lender originates a mortgage loan to a homeowner and receives regular payments of principal and interest from the homeowner over the life of the loan
  2. The lender sells off the mortgage to a financial institution, such as a bank, which then bundles it with other mortgages and creates an MBS
  3. The MBS is then sold to investors, who receive a share of the cash flows generated by the underlying mortgages
  4. The cash flows generated by the underlying mortgages are used to pay interest and principal to the investors in the MBS
  5. The value of the MBS can rise or fall based on changes in the value of the underlying mortgages, interest rates, and other factors

Types Of Mortgage-Backed Securities

There are a few types of mortgage-backed securities on the market, which differ in terms of structure and government involvement:

  • Pass-through securities - Pass-throughs are the most basic type of MBS, where investors receive a pro-rata share of the cash flows generated by the underlying mortgages. Payments are made monthly and are based on the amount of principal and interest collected from the homeowners
  • Collateralized Mortgage Obligations (CMOs) - CMOs are structured securities that divide the cash flows generated from the underlying mortgages into different classes of varying risk levels. Each level is assigned a priority in receiving principal and interest payments and investors can choose which level to invest in, based on their risk tolerance and expected returns
  • Stripped MBS - These are securities where the principal and interest payments from the underlying mortgages are separated into separate securities that can be traded separately. Investors either get the interest-only (IO) or principal-only (PO) securities, which only pay the interest and principal, respectively 
  • Agency MBS - These are mortgage-backed securities that are guaranteed by government-sponsored entities, such as Fannie Mae, Freddie Mac, or Ginnie Mae, and are generally considered to be lower in risk since they are sponsored by the government
  • Non-agency MBS - These are mortgage-backed securities that are not guaranteed by government-sponsored agencies. Such MBS-s are often made up of mortgages that do not comply with the strict criteria of government agencies, such as subprime mortgages

How To Invest In Mortgage-Backed Securities

Much like any other financial security, investors can buy mortgage-backed securities using a few different methods, such as:

  • Mutual funds and ETFs - Investors can choose to invest in funds that are made up of mortgage-backed securities. One such fund is the SPDR Portfolio Mortgage Backed Bond ETF, which has net assets of $4 billion in mortgage-backed securities
  • Direct investment - Investors can also purchase individual MBS directly from brokers or dealers. This approach requires more expertise in analyzing the underlying mortgages and assessing the credit risk associated with them
  • Real-estate investment trusts - Some REITs invest in mortgage-backed securities - giving investors access to MBS investments
  • Mortgage-focused hedge funds - Several hedge funds invest in mortgage-backed securities, which could be an attractive alternative for some investors
  • Underlying mortgage investments - Investors can also invest directly in the underlying mortgages by purchasing mortgage loans from lenders. However, doing so requires a lot of expertise and is generally not advisable for inexperienced investors

Before investing in mortgage-backed securities, investors should consider the yield on these investments, as well as the creditworthiness of the underlying mortgage, to decide whether the risk/reward ratio is the right fit for them. 

Pros and Cons Of Investing In Mortgage-Backed Securities

It is crucial for investors to first understand the inherent risks and rewards associated with investing in MBS-s - before putting their capital at risk. 


  • Higher yield potential - Some mortgage-backed securities are riskier than others, which leads to them having higher potential returns 
  • Diversification - MBS can offer diversification benefits to a portfolio by adding exposure to the housing market, which is generally uncorrelated with the stock market
  • Predictability - MBS offers predictable cash flows as investors receive regular interest payments based on the performance of the underlying mortgages


  • Interest rate risk - One of the biggest downsides of investing in MBS is the effect of interest rate changes. If interest rates rise, the value of the MBS may decline as investors demand higher yields to compensate for the increased risk
  • Prepayment risk - There is always a risk homeowners will pay off their mortgages early, which reduces the cash flow for investors
  • Credit risk - Mortgage-backed securities carry credit risk, as homeowners could default on their mortgage payments. This risk is especially high for subprime mortgages

Key Takeaways From Mortgage-Backed Securities and How To Invest In Them

  • Mortgage-backed securities are financial instruments that consist of mortgages and generate cash flows through interest and principal payments made by homeowners
  • MBS-s were critical to the 2008 financial crisis
  • There are several different mortgage-backed securities, such as government-sponsored agency MBS, CMOs, and pass-throughs
  • Investors can invest in mortgage-backed securities directly, or through mutual funds, ETFs, or REITs
  • The biggest risk in investing in mortgage-backed securities is the risk of homeowners defaulting on their mortgages, as happened during the 2008 financial crisis

FAQs On Mortgage-Backed Securities

Are mortgage-backed securities risk-free?

No. As with any financial instrument, mortgage-backed securities also come with a fair amount of risk. Credit risk is the most important one to consider, as homeowners could default on their mortgages, which renders the MBS worthless. 

Should I invest in mortgage-backed securities?

Most mortgage-backed securities are considered to be of low risk. Investors need to conduct thorough due diligence regarding the credit ratings of mortgages within an MBS to decide whether the potential returns are worth the risk. 

What is an agency MBS?

An agency mortgage-backed security is a type of MBS that is guaranteed by a government-sponsored agency like Fannie Mae or Freddie Mac.