Which statement best describes the benefit of Mortgage Backed Securities compared with other debt securities of similar credit ratings?

• A. They pay a higher rate of return
• B. They have lower credit risk
• C. They have guaranteed principal
• D. They have zero prepayment risk

Answer: (A)

The key idea is that mortgage-backed securities carry prepayment risk, and investors require a higher yield to compensate for that uncertainty in cash flows. In a pool of mortgages, borrowers can refinance and pay off principal early if rates drop. That means the security’s principal may be returned sooner than expected, and the investor then must reinvest that money at potentially lower prevailing rates. To attract investors despite this risk, MBS typically offer a higher coupon/ yield than other debt with the same credit quality. So the main benefit compared with similar-rated debt is the higher rate of return to compensate for prepayment and reinvestment risk. Principal isn’t guaranteed in MBS, and there is prepayment risk, not zero prepayment risk, and the credit risk isn't inherently lower just because the rating is similar.