Which of the following is NOT listed as a risk to investors in Mortgage Backed Securities?

• A. Inflation risk
• B. Prepayment risk
• C. Default risk
• D. Liquidity risk

Answer: (A)

Mortgage-Backed Securities have several distinct risks that can affect returns, with prepayment risk being a central concern. When interest rates drop, borrowers may refinance or pay off their loans early, returning principal to the investor sooner and forcing reinvestment at potentially lower rates, which can shorten the security’s effective duration. Default risk matters mainly for non-agency MBS, where underlying borrowers may fail to repay, whereas agency MBS have guarantees that reduce this risk. Liquidity risk is another issue: MBS markets can be less liquid, making it harder to sell without taking a price hit. Inflation risk, while relevant to all fixed-income investments, isn’t typically listed as a distinct risk specific to MBS in standard practice or exams.