Can the Yield to a Purchaser of a Mortgage-Backed Security Change During the Time of Ownership?

Calculating Yield

Yield-to-maturity is the most important factor to investors because it reflects the annual rate of return on the bond held to maturity. A traditional bond purchased at a $10,000 par value with a coupon rate of 5 percent would have a yield-to-maturity of 5 percent. Since the purchase price equaled the par value for the bond, the yield-to-maturity is the same as the coupon rate. The coupon rate does not change on a traditional bond, thus, only a difference in the price paid for the bond would affect the yield-to-maturity. The principal is returned in full only at maturity, barring a sale of the bond before maturity.

Because the principal of the mortgages within a mortgage-backed security may be repaid at any time during the life of the investment, the yield-to-maturity of the investment is impacted by more than just the price paid. Even under normal circumstances, the amortization method used in mortgage lending means that principal will not be repaid in constant amounts over time. Without prepayments and at prevailing interest rates, a level-payment, fixed-rate mortgage loan with a 30-year amortization schedule would repay one-half of the original principal amount by years 20 to 23. The higher the interest rate, the slower the amortization of principal.

Interruptions of the amortization schedule can dramatically affect yield. For example, an earlier-than-expected return of principal generally increases the yield on securities purchased at a discount. However, when a mortgage-backed security is purchased at a premium, an earlier-than-expected return of principal reduces yield. Consequently, investors in mortgage-backed securities should be more interested in cash flow than yield-to-maturity.

The cash flow of a mortgage-backed security consists of scheduled principal payments, accrued interest payments and potential prepayments of principal. The mortgage investor faces unique prepayment risks, including voluntary prepayments by the mortgagor as a result of a sale of the underlying property, refinance of the mortgage, or, as was the case during the recent financial crisis, default. Predicting cash flow is extremely difficult, and any calculation model will be influenced but its particular assumption or methodology used to forecast how quickly principal will be returned. There is simply no assurance that any particular issue of mortgage-backed securities will conform to past experience or traditional assumptions.