What Is a Pass-Through Security?

A pass-through security is a collection of debt-backed financial securities for which investors purchase shares. Payments pass monthly from the debtors through the issuer, who deducts a fee and divides the remaining payment to the security holders. Inflation puts the securities at risk as they are fixed income, paid at intervals, and vulnerable to early debt contract termination. Mortgage-backed securities issued by government agencies are the most common types of pass-through securities.

The pass-through security investment is created when a private organization or government agency bundles together a collection of debt assets, such as car loans or home mortgages, which are currently being paid off by debtors. Shares of this asset pack are sold to multiple investors. Multiple shares spread the risk in case of default on the part of the debtors.

A debtor then makes monthly principal and interest payments on the loan to the debt’s issuer. This issuing organization accepts the payment and deducts a servicing fee to keep. The remaining payment is divided amongst the shareholders according to share amounts, and payments are made on interval across the life of the contract.

The securities are fixed-income, meaning that the regularly paid amount is a set amount. Inflation can cause that to erode, as it can lower the interest rates that the debtors are paying on the loans. Vastly lowered inflation rates can also inspire debtors to pay off the debt early.

Investors benefit from a longer pass-through security contract since the payments are made on intervals throughout its life. The stated maturity date can be shortened in the case of early payoff. Shareholders lose whatever future payments might have been owed. Credit insurance is often available to protect investors from defaults, but it doesn’t cover the loss of return due to early termination.

The most popular type of pass-through security is mortgage-backed certificates due to a generally lessened risk. A pool of mortgages is formed and backed by a United States governmental agency such as Fannie Mae and Ginnie Mae. Mortgage-backed securities are also available from private organizations, but they carry the standard risk level of a general pass-through security.