What Is a Gross Coupon?
The term “gross coupon” refers to the average coupon rate received from a portfolio of mortgage loans. The term is often used in the market for mortgage-backed securities (MBS) since these mortgage portfolios are the underlying assets on which these MBS products are based.
- The gross coupon refers to the average interest rate of a portfolio of mortgage loans, used to assess the relative yield of different mortgage-backed security products.
- Unlike the weighted average coupon, which takes into account the different sizes of the mortgages when making this calculation, the gross coupon is simply an average of all the underlying mortgages’ interest rates.
- The financial institution selling the mortgage-backed securities typically deducts administrative fees from the gross coupon to produce a net coupon, which is thus always lower than the initial gross coupon.
How Gross Coupons Work
The gross coupon associated with a portfolio of mortgages is calculated by averaging all of the coupon rates from the individual mortgages that make up an MBS. A gross coupon of 5% would therefore mean that, on average, the mortgages contained in the MBS have an interest rate of 5%. Unlike the weighted average coupon, which takes into account the different sizes of the mortgages when making this calculation, the gross coupon is simply an average of all the underlying mortgages’ interest rates.
Typically, a financial institution will create an MBS by first purchasing a portfolio of mortgages from a bank and then packaging them into an MBS which it then sells to investors. In that process, the company creating the MBS will add its own layer of administration and service fees. These fees are deducted from the gross coupon to produce a net coupon, which is thus always lower than the initial gross coupon.
When an investor purchases an MBS, the yield that they receive is based on the net coupon. More specifically, the return earned by the MBS investor is based on the monthly payments made by the homeowners on their mortgages, plus any prepayments made by those homeowners, minus the servicing costs charged by the company that packaged and sold the MBS. Because homeowners pay their mortgages each month, the returns earned by MBS investors are also paid out monthly.
Real-World Example of a Gross Coupon
Dorothy is searching for fixed-income investments that she can use to enhance the yield on her retirement savings. She has decided to invest $100,000 of her retirement savings into an MBS, as she believes these instruments will offer a higher average yield than conventional debt securities.
In researching these investments, Dorothy finds several mortgage-backed securities offering a gross coupon of 6%. She understands that this rate is based on the average interest rate charged on the mortgage-backed securities' underlying pool of mortgages, before taking into account the various fees charged by the firm managing the MBS. By contrast, the weighted average coupon reflects the relative size of the different mortgages inside the portfolio.