What form of risk is most associated with mortgage-backed securities?

The form of risk that is most closely associated with mortgage-backed securities is prepayment risk. Mortgage-backed securities are created by pooling together mortgages and then issuing securities that are backed by these mortgage loans. One of the unique characteristics of such securities is that borrowers have the option to prepay their mortgages, often when interest rates fall. This prepayment introduces uncertainty into the cash flow of the mortgage-backed security, as investors may receive their principal back sooner than expected.

When borrowers prepay their loans, the investors in mortgage-backed securities may have to reinvest the returned principal at lower interest rates, which can adversely affect the returns they receive. Consequently, prepayment risk is a significant concern for investors because it impacts the timing and amount of cash flows that they can anticipate.

In contrast, while interest rate risk, credit risk, and liquidity risk are relevant to a variety of fixed-income securities, the unique structure of mortgage-backed securities makes prepayment risk the most critical factor in managing the investment in these assets.