Mortgage-Backed Security (MBS)
A bond backed by a pool of home mortgages, passing borrower payments through to investors — and a key target of Fed QE.
A mortgage-backed security (MBS) is a bond whose cash flows come from a pool of residential mortgages. Homeowners' monthly principal-and-interest payments are "passed through" to MBS holders. Agency MBS — issued or guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae — carry minimal credit risk but full prepayment risk; the multi-trillion-dollar agency MBS market is second only to Treasuries in size.
The defining quirk is negative convexity. When rates fall, homeowners refinance and prepay, so principal is returned at par precisely when a normal bond would be rallying — capping the MBS's price gain and forcing reinvestment at lower rates. When rates rise, prepayments slow and the bond's effective life extends right as the holder would prefer to get cash back (extension risk). MBS therefore underperform Treasuries on big rate moves in either direction.
The practical edge: the Fed buys agency MBS during QE specifically to suppress mortgage rates, making MBS spreads a direct transmission channel from monetary policy to the housing market.
Related Terms
Bond
A debt instrument in which the issuer borrows money from the buyer and promises to pay periodic interest plus return the principal at maturity.
BeginnerConvexity
The curvature in the price-yield relationship of a bond — measuring how duration itself changes as yields move, improving accuracy of price change estimates.
AdvancedCredit Spread
The yield difference between a corporate (or other non-government) bond and a Treasury of the same maturity — the market's price for credit risk.
IntermediateDuration
A measure of a bond's sensitivity to interest rate changes — the approximate percentage price change for a 1% move in yield.
AdvancedQuantitative Easing
A Fed policy of purchasing Treasury bonds and MBS to inject liquidity, lower long-term yields, and stimulate the economy when short rates are near zero.
Intermediate