What Is a Pass-Through Security and How Does It Work?

Pass-through securities offer a distinct investment structure, allowing income generated from a pool of underlying assets to be directly transferred to investors. This article will explore the nature of pass-through securities, detail the process through which they are created, and provide examples of their common applications in financial markets.

Understanding Pass-Through Securities

A pass-through security fundamentally represents an interest in a pool of income-generating assets, typically fixed-income instruments. The core characteristic of these securities is that the principal and interest payments made by the original borrowers of the underlying assets are collected and then “passed through” directly to the investors holding the security. This structure contrasts with other securities where the issuing entity retains the cash flows and pays investors from its general funds.

The “pass-through entity,” often structured as a Special Purpose Vehicle (SPV), is a legally distinct entity created specifically to acquire and hold the pooled assets. Its independence ensures that the assets and their cash flows are isolated from the financial risks, such as bankruptcy, of the original lender or “originator” of the assets. Investors in a pass-through security essentially own an undivided interest in the ongoing cash flows generated by this specific pool of underlying assets.

For tax purposes, many pass-through entities, including certain SPVs, are designed to avoid taxation at the entity level. This means that the income generated by the underlying assets is not taxed at the SPV level but is instead passed through directly to the investors, who then report and pay taxes on that income. This structure aims to prevent double taxation, where income would be taxed at both the entity and investor levels.

The Securitization Process Explained

The creation of pass-through securities involves a financial process known as securitization, which transforms illiquid assets into marketable securities. This process typically begins with an “originator,” such as a bank or financial institution, extending loans or creating receivables. The originator then identifies and pools a large number of these similar assets, such as residential mortgages or auto loans, based on characteristics like interest rates, maturities, and payment frequencies.

These pooled assets are subsequently sold and legally transferred to a newly established Special Purpose Vehicle (SPV). This sale removes the assets from the originator’s balance sheet, which can free up capital for the originator to make new loans and reduce its risk exposure. The SPV, now the legal owner of the asset pool, then issues new securities to investors, with the cash flows from the acquired assets serving as collateral.

Once the securities are issued, a servicer, often the original lender, is typically responsible for collecting the monthly principal and interest payments from the individual borrowers in the underlying pool. After deducting servicing fees and any other administrative expenses, the servicer remits these collected payments to the SPV. The SPV then distributes these cash flows to the investors who hold the pass-through securities, in proportion to their ownership interest.

Common Examples

Mortgage-Backed Securities (MBS) are a prominent example of pass-through securities and are among the most common types. These securities are backed by pools of residential or commercial mortgages. As homeowners make their monthly mortgage payments, including both principal and interest, these payments are collected, aggregated, and then passed through to the MBS investors. Major issuers of MBS include government-sponsored enterprises like Fannie Mae and Freddie Mac, and government agencies such as Ginnie Mae, which often guarantee the timely payment of principal and interest to investors.

However, the actual cash flow to investors can vary due to factors like mortgage prepayments, where homeowners may refinance or sell their homes, leading to earlier-than-expected principal returns. Many MBS are structured through Real Estate Mortgage Investment Conduits (REMICs), which are specifically designed under the Internal Revenue Code to be tax-neutral entities, ensuring that income and expenses are passed through to investors without being taxed at the conduit level.

Asset-Backed Securities (ABS) represent another significant category of pass-through instruments, encompassing a broader range of underlying assets beyond real estate mortgages. These securities are created from pools of diverse financial assets that generate predictable cash flows. Common examples include auto loans, credit card receivables, student loans, and equipment leases. The process for ABS mirrors that of MBS; payments from the underlying loans or receivables are collected from the original borrowers and then distributed to the ABS investors.

ABS allows originators to convert illiquid assets, such as a large portfolio of individual auto loans, into liquid and tradable securities. This mechanism provides financial institutions with a means to raise capital and manage their balance sheets more efficiently. While the specific characteristics of the cash flows depend on the nature of the underlying assets—for instance, credit card receivables might have revolving balances compared to the fixed payments of an auto loan—the fundamental pass-through principle remains consistent across all ABS types.