What are Pass-Through Securities?

Pass-through securities are a type of investment created by pooling together loans — most commonly mortgages — and passing the payments from those loans through to investors. They're a foundational product in the world of securitisation and fixed income. This guide explains what pass-through securities are, how they work, their risks, and why they matter — in clear, plain language. They're closely related to collateralized debt obligations and are a relevant topic in qualifications like the FRM.

What is a pass-through security?

A pass-through security is created when a pool of loans — such as residential mortgages — is bundled together, and the monthly payments made by the borrowers (both interest and principal) are collected and "passed through" to the investors who hold the security. The most common example is the mortgage-backed security (MBS) of this type. An investor in a pass-through security effectively owns a share of the cash flows from the underlying pool of loans — receiving a proportional slice of the principal and interest payments as borrowers make them, usually monthly, minus a servicing fee.

How pass-through securities work

The process is a form of securitisation:

• A lender (such as a bank) originates a large number of loans — say, mortgages.
• These loans are pooled together and used to create securities, which are sold to investors.
• As borrowers make their monthly payments, the cash — principal and interest — flows through a servicer to the investors, in proportion to their holdings.

This benefits the original lender, who converts illiquid loans into cash they can lend again, and gives investors access to a stream of income backed by a diversified pool of loans. Unlike a CDO, a basic pass-through doesn't slice the pool into different risk tranches — every investor shares proportionally in the same cash flows from the whole pool.

The key risk: prepayment

The most distinctive feature of pass-through securities is prepayment risk. Borrowers can repay their loans early — for instance, mortgage holders refinancing when interest rates fall, or moving house. When they do, that principal is passed through to investors sooner than expected. This creates uncertainty about the timing of the cash flows, which is a particular challenge:

• When interest rates fall, prepayments tend to rise (borrowers refinance), so investors get their money back early — and have to reinvest it at the new, lower rates.
• When interest rates rise, prepayments tend to slow, so investors are stuck holding a lower-yielding security for longer.

This "heads you lose, tails you lose" timing problem — receiving cash at the least convenient times — is the defining risk of pass-through securities, and it makes them behave differently from ordinary bonds.

Why pass-through securities matter

Pass-through securities are a cornerstone of the modern mortgage and fixed-income markets. They channel money from investors into mortgage lending, helping make home loans more available and affordable, and they give investors access to a large, income-producing asset class. They were also central to the development of the wider securitisation market — and to the 2008 financial crisis, when mortgage-related securities built on poor-quality loans suffered severe losses. Understanding them is key to understanding both the benefits and the risks of securitisation.

Why it matters for finance professionals

For anyone in fixed income, banking or risk, pass-through securities are an important concept. They illustrate how securitisation works, introduce the crucial idea of prepayment risk, and underpin a vast and significant market. Understanding how they generate and distribute cash flows — and why prepayment makes them tricky to value — is valuable in fixed-income analysis and a regularly relevant topic in professional risk qualifications and exams.

Frequently asked questions

What is a pass-through security?

An investment created by pooling loans (commonly mortgages) and passing the borrowers' payments through to investors, who each receive a proportional share of the principal and interest from the pool.

How do pass-through securities work?

A lender pools loans and sells securities backed by them; as borrowers make payments, the cash flows through a servicer to investors in proportion to their holdings. A basic pass-through doesn't split the pool into risk tranches.

What is prepayment risk?

The risk that borrowers repay their loans early — passing principal to investors sooner than expected. It's worst when rates fall (more refinancing) and forces investors to reinvest at lower rates.

Why do pass-through securities matter?

They channel investor money into mortgage lending, making home loans more available, and give investors an income-producing asset class. They were also central to securitisation and the 2008 crisis.

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Pass-through securities are a key part of fixed-income and securitisation. Learnsignal's tutor-led courses, including the FRM, develop the fixed-income and risk understanding that topics like this build on — with clear teaching that connects theory to real markets.