Interest Rates and Yields on CMOs
The interest rates paid on CMOs will be lower than the interest rates paid on the underlying mortgage loans, because the issuer retains a portion of the interest paid by the mortgage borrower as a “servicing fee” for creating the security and for collecting and distributing the monthly payments to investors. Still, newly issued mortgage securities carry higher estimated yields than comparable Treasury securities. In part, this is because the interest rates paid by home buyers are higher than the interest rates paid by the U.S. government. However, the higher interest rates on mortgage securities also reflect compensation for the uncertainty of their average lives.
As with any bond, the yield on a CMO depends on the purchase “price” in relation to the interest rate and the length of time the investor’s principal remains outstanding. CMO yields are often quoted in relation to yields on Treasury securities with maturities closest to the CMO’s estimated average life. The estimated yield on a CMO reflects its estimated average life based on the assumed prepayment rates for the underlying mortgage loans. If actual prepayment rates are faster or slower than anticipated, the investor who holds the CMO until it is fully paid may realize a different yield. For securities purchased at a discount to face value, faster prepayment rates will increase the yield-to-maturity, while slower prepayment rates will reduce it. For securities purchased at a premium, faster prepayment rates will reduce the yield-to-maturity, while slower rates will increase it. For securities purchased at face value (“par”), these effects should be minimal.
Because CMOs pay monthly or quarterly, as opposed to the semiannual interest payment schedule for most bonds, CMO investors can use their interest income much earlier than other bond investors. Therefore, CMOs are often discussed in terms of their “bond equivalent yield,” which is the actual CMO yield adjusted to account for its greater present value resulting from more frequent interest payments.
All information and opinions contained in this publication were produced by the Securities Industry and Financial Markets Association from our membership and other sources believed by the Association to be accurate and reliable. By providing this general information, the Securities Industry and Financial Markets Association makes neither a recommendation as to the appropriateness of investing in fixed-income securities nor is it providing any specific investment advice for any particular investor. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and sources may be required to make informed investment decisions.