What Is an Amortizing Security
An amortizing security is a class of debt investment in which a portion of the underlying principal amount is paid in addition to interest with each payment made to the security's holder. The regular payment that the security holder receives is derived from the payments that the borrower makes in paying off the debt. Amortizing securities are debt-backed, meaning a loan or a pool of loans has been securitized. From the borrower's perspective, nothing has changed from the original loan agreement, but the payments made to the bank flow through to the investor who holds the security created from the loan.
Breaking Down Amortizing Security
Amortizing securities are debt securities like bonds, but they pay the principal back with each payment rather than upon maturity. Mortgage-backed securities (MBS) are among the most common forms of amortizing security. With an MBS, the monthly mortgage payments that the borrowers make are pooled together and are then distributed to MBS holders. This is an excellent system for freeing up credit to issue more loans as long as the creditor is properly vetting borrowers. Amortizing securities in the form of mortgages and NINJA loans were at the center of the mortgage meltdown.
Amortizing Securities and Prepayment Risk
Depending upon the way in which a security is structured, holders of amortizing securities may be subject to prepayment risk. It is not uncommon for the underlying borrower to prepay a portion, if not all, of the debt's principal if interest rates drop to a point where refinancing makes financial sense. In the event that prepayment occurs, the investor will receive the rest of the principal and no more interest payments will occur. This leaves the investor with dollars to invest in a lower interest environment than was likely the case when they purchased the amortizing security. As a consequence, the investor will lose out on interest that they may have otherwise enjoyed if they hadn't chosen an amortizing security. This is also referred to as reinvestment risk, and it is part of the tradeoff investors must make for a higher interest rate on an amortizing security compared to a non-amortizing bond.
Stripping Amortizing Securities
Because of the unique two-portion payments, an amortizing security can be stripped into interest-only and principal-only products, or some combination where the proportion of the two are unequally allotted to a tranche. The interest-only strip will take on all the prepayment risk and the principal-only strip actually benefits from prepayment because the investor gets the money back sooner, benefiting from the time value of money since there is no interest coming anyway. In this case, the two strips of an amortizing security become proxies for the investor's thesis on the future movement of interest rates.