What Are Mortgage-Backed Securities (MBS)?

An investor researching how mortgage-backed securities work.

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Mortgage-backed securities (MBS) are investments made up of bundled residential or commercial mortgages sold to investors. As homeowners make their monthly payments, investors receive returns. These securities help lenders continue issuing new loans, keeping the housing market active. Some MBS are backed by government agencies, while others carry more risk depending on borrower repayment. A financial advisor can help assess MBS investment risks, compare options and determine if they fit your overall portfolio strategy.

Mortgage-backed securities (MBS) transform individual home loans into tradable financial assets. The process works like this:

1. Banks and mortgage lenders originate home loans.

2. Individual loans are combined into pools of similar loans.

3. Pools are packaged as securities.

4. These securities are sold to government-sponsored enterprises or private investors.

5. Investors who buy these securities receive the interest and principal payments made by borrowers who took out the loans.

While MBS provide opportunities for steady income, their value fluctuates with the housing market and credit conditions, making them sensitive to economic cycles. Prepayment risk is a key consideration for MBS investors. If homeowners refinance or pay off mortgages early, it can affect cash flows to investors.

Mortgage-backed securities come in several forms, each with distinct structures and risk profiles. The primary types are pass-through securities and collateralized mortgage obligations (CMOs). Additional variations exist within these broad categories. The performance of MBS of any variety depends on factors like interest rates, borrower repayment behavior and broader economic trends.

Pass-through securities are the simplest form of MBS. These securities pool together mortgage loans and pass the principal and interest payments directly to investors. They often have fixed interest rates and predictable cash flows, but they remain susceptible to prepayment risk, which can impact the duration and returns of the investment. Since they are not actively managed, pass-through securities provide a cost-efficient and straightforward way for investors to gain exposure to the mortgage market.

CMOs break mortgage pools into tranches, or segments, that offer different levels of risk and return. Some tranches receive payments first and have lower risk, while others carry higher yields but face greater uncertainty in cash flows.

This structure allows investors to choose a tranche that aligns with their risk tolerance and income needs. CMOs also help manage prepayment risk by structuring tranches with different maturities, providing investors with more control over expected cash flows.

MBS also vary based on the institution that issues them.

Agency MBS are issued or guaranteed by government-sponsored enterprises like Fannie Mae, Freddie Mac or Ginnie Mae. These securities carry lower credit risk because they have implicit or explicit government backing, making them attractive to conservative investors.

Non-agency MBS, on the other hand, are issued by private financial institutions without government guarantees. They tend to offer higher yields but come with greater risk, as their performance depends on borrower credit quality and overall market conditions.

An investor looking up the history of MBS.

Mortgage-backed securities emerged in the late 1960s as part of an effort to increase liquidity in the housing market. Ginnie Mae issued the first MBS in 1970, providing a way for lenders to sell mortgages and reinvest capital into new loans. Over time, private institutions developed their own MBS, expanding investment opportunities beyond government-backed securities.

The 2008 financial crisis exposed weaknesses in the MBS market. Many non-agency MBS were backed by subprime mortgages, which are loans issued to borrowers with weak credit histories. When housing prices declined, defaults surged, causing significant losses for investors. The crisis led to tighter regulations, including the Dodd-Frank Act, which introduced stricter lending standards and increased oversight of mortgage-backed securities.

Following the crisis, the MBS market has become more regulated, with a stronger emphasis on credit quality and transparency. Agency MBS remain a popular investment due to their government backing, while non-agency MBS have undergone reforms to reduce risk exposure. Investors now rely on more robust underwriting and risk assessment practices, making the market more stable than before. While MBS continue to play a key role in housing finance, their evolution reflects lessons learned from past financial instability.

Investors can access mortgage-backed securities (MBS) through several channels, including brokerage accounts and direct purchases from government-sponsored entities. To buy MBS directly, open an account with a brokerage that offers them, such as Fidelity or Charles Schwab. Many brokerages provide access to agency MBS issued by Fannie Mae, Freddie Mac and Ginnie Mae.

Another option is to invest in MBS-focused mutual funds or exchange-traded funds (ETFs). These funds offer diversification and professional management while maintaining exposure to mortgage-backed securities. Some examples include the iShares MBS ETF (MBB) or the Vanguard Mortgage-Backed Securities ETF (VMBS).

Institutional and accredited investors can purchase MBS through the Federal Reserve’s auction process or directly from government-sponsored entities. Additionally, some hedge funds and private investment firms offer structured MBS investments.

For those seeking indirect exposure, real estate investment trusts (REITs) specializing in MBS, such as Annaly Capital Management (NLY) or AGNC Investment Corp. (AGNC), provide an alternative. Before purchasing, review the credit quality, prepayment risk and yield potential of the securities to align with your investment goals.

Mortgage-backed securities (MBS) can offer investors an income-generating asset with varying levels of risk and return. They provide exposure to the real estate market without directly owning property, but they also come with complexities such as prepayment risk and sensitivity to interest rate fluctuations.

• Regular income: Many MBS provide predictable monthly interest payments.

• Government-backed options: Agency MBS offer lower credit risk due to implicit or explicit government backing.

• Diversification: MBS can add fixed-income exposure to a portfolio.

• Competitive yields: MBS yields can be higher than Treasury bonds of similar duration.

• Prepayment risk: Borrowers refinancing or repaying loans early can reduce expected returns.

• Interest rate sensitivity: MBS prices fluctuate with changes in interest rates.

• Liquidity concerns: Some MBS, particularly private-label securities, may be harder to sell.

• Complexity: Understanding the structure and risks requires more analysis than traditional bonds.

An investor reviewing her real estate investment portfolio.

Mortgage-backed securities can offer a way for investors to participate in the housing market without directly owning property. They can generate income, but carry risks tied to interest rates, prepayment behavior and broader economic conditions. Agency MBS provide a more stable option due to government backing. Non-agency securities present higher potential returns alongside greater risk.

• A financial advisor can help you identify real estate investment opportunities and manage risk for your portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

• If you want to diversify your portfolio, here’s a roundup of 13 investments to consider.

• When you are making a real estate transaction, closing costs can be a significant consideration. SmartAsset’s closing costs calculator helps you estimate how much cash will change hands at closing.

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