Mortgage-Backed Securities: Risks, Rewards and Realities

Investing in mortgage-backed securities (MBSs) enables you to have exposure to the housing market without owning real estate outright. The 2008 financial crisis has given these debt investments a bad name, and rightfully so. However, they’ve changed since The Big Short.

What Are Mortgage-Backed Securities?

MBSs are secured bonds that generate income from payments of the underlying mortgages. Every MBS is a pool of loans, often with similar attributes, sold to multiple investors.

The key players in the formation of MBSs are borrowers, lenders, issuers, credit rating agencies, investors and servicers. Here’s how it works:

• A borrowers take out a mortgage, and then a lender originates the loan if the applicant is qualified.
• The lender pools mortgages and sells them to third parties, such as government-sponsored enterprises (GSEs) and trusts, that would structure them as MBSs or repackage the loans themselves and become issuers.
• A credit rating agency evaluates the newly packaged MBS deal, analyzing the quality of underlying mortgages, the lender’s processes and the servicer’s ability to manage collections to help investors assess risk more effectively.
• The issuer sells MBSs through brokers, although investors can gain exposure to these debt investments by buying shares of the exchange-traded funds, mutual funds and mortgage real estate investment trusts holding MBSs.
• The servicer collects payments from borrowers and distributes the funds to MBS investors.

Pass-through MBSs have a simple structure, proportionally passing the collected principal and interest payments to investors. In contrast, collateralized mortgage obligations consist of a collection of loans divided into tranches, giving you more control over risk and returns.

What Are the Risks of MBSs?

These debt investments exist to supply liquidity to mortgage lending. The lenders want to realize their profits more quickly and have the capital to originate more loans. Sold mortgages are a plus on the balance sheet, transferring risk to MBS investors and protecting lenders from losses in the event of borrower default.

If you invest in an MBS, you’ll become a creditor that has claims on the payments borrowers make. Ideally, you want to receive payouts until your security’s underlying loans mature. However, there’s a strong chance that you may not realize your anticipated gains due to market conditions and borrower decisions.

As an MBS investor, be wary of interest rate, prepayment and liquidity risks. Mortgage-backed securities are sensitive to rate fluctuations, as the desirability of existing MBS values depends on the yields new bonds can offer.

When interest rates spike, existing MBSs become less valuable because the newer securities will offer higher returns. When rates fall, MBS prices go up. However, cheaper rates incentivize borrowers to refinance and pay off their loans ahead of schedule. Prepaid mortgages result in reduced returns for MBS investors due to inadequate interest payments.

Investors can sell MBSs in the secondary market as they see fit. However, some securities are more liquid than others. Agency MBSs — those issued by GSEs — enjoy higher demand due to the backing of the United States government and are therefore easier to resell. Private-label MBS issued by financial institutions carry more risk, generate less interest from investors and ultimately have limited liquidity.

What Are the Benefits of MBSs?

MBSs are an attractive and safe investment, as they typically offer higher yields than U.S. Treasuries and similarly rated corporate bonds, and and provide monthly payouts instead of a lump-sum payment at loan maturity. The U.S. federal government insures agency MBS investors against losses related to default.

These debt securities are excellent for diversification. They have low correlation with the stock market and corporate bonds, allowing you to hedge your other investments and protect your capital.

MBS benefits are contingent upon the belief that all parties involved perform their roles diligently. Otherwise, loans originated based on ultralenient standards and securities rated generously can form a housing bubble and wipe out massive wealth when it bursts.

What Are the Disadvantages of MBSs?

The disadvantages of MBSs are tied to interest rate, prepayment and liquidity risks. They become less valuable on the secondary market when rates increase. Securities without the backing of the U.S. government receive less demand and are more challenging to convert into cash when you decide to offload them.

Rate drops can make your MBSs more valuable relative to newly issued ones. However, lower interest rates entice borrowers to refinance and pay off their more expensive mortgages earlier, reducing your expected returns.

Why Do Investors Buy MBSs?

Most investors who gravitate toward MBSs seek exposure to real estate in a manner that generates steady income and greater returns than other popular securities. Most are proof against default and are liquid enough to let you cut losses when market conditions become less favorable. Some appeal to investors with higher risk tolerances and a preference for larger payouts.

MBSs represent a low-risk and low-effort way to bet on the housing market, which is historically a safe place to park capital and build wealth. According to Zillow’s estimation, the U.S. housing market’s value had reached $55.1 trillion by June 2025. Although home prices in some regions have been cooling, the overall size of the pie continues to grow due to consistent demand and chronically inadequate supply.

Proponents and critics can argue for and against the sustainability of real estate growth, but today’s MBSs are unlikely to cause a housing bubble similar to the one that burst in the late ’00s, due to increased scrutiny from policymakers and investors.

Whales hold most of the MBSs today. The higher share is under the management of banks, while the Federal Reserve is also a prolific buyer of these securities to help stabilize financial markets.

Although you can personally oversee your positions, many retail investors use the expertise of money managers to minimize risk, especially when holding nonagency MBSs. International entities, particularly Japanese, Taiwanese and Chinese investors, are also major MBS holders and buy up supply when demand weakens domestically.

Mortgage-Backed Securities — The Least Risky Path to Real Estate Investing

Nothing in investing is a slam dunk, but few opportunities can match the MBS’s risk/return ratio. Explore the different types of available debt investments to find the ones that fit your financial goals and risk tolerance.