What is the greatest risk associated with mortgage-backed securities?

The greatest risk associated with mortgage-backed securities is often linked to falling interest rates leading to early principal repayment. When interest rates decline, homeowners are more inclined to refinance their mortgages at lower rates, which results in early repayment of the principal on the mortgage-backed securities. This can create a situation where investors receive their principal back sooner than anticipated, limiting the time over which they earn interest on those securities.

This risk is particularly significant in a declining rate environment because it can disrupt the expected cash flow of mortgage-backed securities, potentially impacting their yield. Investors may find that they have to reinvest the returned principal at lower rates, thus reducing their overall returns. This contrasts with other risks associated with mortgage-backed securities, such as rising interest rates or defaults, which, while they can also be significant, do not directly address the specific dynamics of early repayment due to refinancing when rates fall.