Credit · C12 · 9 min

Mortgage-backed securities II: market structure

See how mortgage bonds trade before the pools exist, which slices win as rates move, and why MBS hedging can push Treasuries further.

In the news: “Mortgage hedgers added to the Treasury sell-off”: how holders of mortgage bonds can turn a rates move into a bigger one.

The essentials

TBA trade: How most US trade: the coupon, maturity, price and settlement month are agreed, and the seller names the pools two days before settlement. It delivers the that qualify, so TBA prices reflect them.
Specified pools and pay-ups: Pools whose borrowers repay slowly, such as small loans, are worth more than the TBA and trade at a pay-up, quoted in 32nds like Treasuries: 102-00 against 101-08 is 24/32, or 0.75 points.
CMOs: A splits a pool’s payments into classes. In a sequential CMO, class A takes all principal until it is repaid, then class B. A PAC keeps a set schedule within a band of speeds; a support class absorbs the rest.
IO and PO: of a pool’s interest (IO) and principal (PO). Falling rates speed up repayment, so the PO, bought below 100, gains. The IO loses then, as interest stops on each loan repaid, so it gains when rates rise.
Convexity hedging: When rise, lengthen, so holders who keep their fixed sell Treasuries or pay fixed in swaps, pushing yields higher still; when yields fall they buy. Their hedging adds to rate moves.

Specified-pool pay-up

pay-up = specified-pool price − TBA price

pay-up: the premium for a pool that repays slowly, usually quoted in 32nds

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How it works

1. Trading before the pools exist

Most US agency MBS trade before the buyer knows which pools of mortgages it will get. Buyer and seller agree the coupon, maturity, price and settlement month; the seller names the pools two days before settlement. This is a (to-be-announced) trade.

2. The seller delivers the worst

Any pools that meet the standard will do, so sellers hand over the least valuable ones. TBA prices therefore reflect the worst pools that qualify, the , as with bond futures.

3. Prices in 32nds

MBS prices are quoted in 32nds of a point, like Treasuries: 101-08 means 101 and 8/32, or 101.25.

4. Specified pools

Some pools are worth more than the TBA because their borrowers repay slowly, such as pools of small loans, where refinancing saves less money. These trade at a pay-up over the TBA price: 102-00 against 101-08 is a pay-up of 24/32.

5. Splitting a pool into classes

A slices one pool’s payments into classes. In a sequential CMO, class A gets all the principal until it is repaid, then class B. So A is a short bond and B a long one, and B’s life changes most when repayments speed up or slow down.

6. Planned and support classes

Another design gives a PAC (planned amortisation class) a fixed repayment schedule while repayment speeds stay within a band. A support class takes the difference, shortening when repayments jump and lengthening when they slow, and pays more for that risk.

7. Interest only, principal only

split a pool into its interest (IO) and its principal (PO). The PO is bought below 100 and gains when repayments speed up, because the money comes back sooner. The IO loses then, because interest stops on every loan repaid, so it gains when rates rise.

8. Hedging that adds to moves

Holders who keep their interest-rate exposure fixed must trade with the market. When rates rise, MBS lengthen, so they sell Treasuries or pay fixed in swaps, pushing yields higher still; when rates fall, they buy. That is .

9. The Fed’s mortgage bonds

The Fed bought agency MBS during and let them run off during . From 1 December 2025 it stopped shrinking its balance sheet, but it puts the money from its maturing MBS into , so its MBS holdings keep falling.

Worked example

A 30-year agency MBS TBA trades at 101-08. A pool of small loans with the same coupon trades at 102-00. You buy $10m of the pool, and then mortgage rates fall 1 point.

Pay-up: 102-00 − 101-08 = 24/32 = 0.75 points.
In money: 0.75% × $10m = $75,000 more than the TBA.
In the rally, generic pools repay fast; small-loan borrowers save less by refinancing, so your pool repays more slowly.
Its above-market coupon lasts longer, so its price holds up better than the TBA’s.

You pay $75,000 over the TBA for slower repayment, a premium that tends to grow when refinancing picks up.

Check yourself

9 quick questions on the explanation above.

Practice

New numbers every set. Misses and guesses go into your review deck.

In the interview

Answer out loud in under a minute, then compare.

What’s a TBA?
How can MBS hedging make a bond sell-off worse?
If rates fall sharply, would you rather own an IO or a PO?

Remember

Pay-up = specified pool − TBA price

The TBA prices the worst pools; anything that slows repayment earns a pay-up, and hedging MBS adds to rate moves.

Sources

Definitions and maths are standard textbook material; dated facts link to the sources above. Worked numbers are illustrative.