With competitive yields on offer, mortgage-backed securities (MBS) have emerged as a significant segment of the fixed-income market, worth over US$12 trillion globally as of early 2025.

However, MBS are solely an income play, so why not just buy real property and get income and equity growth?

The reason is simple: MBS sit between bonds and property in terms of investment risk but offer a potentially higher yield to bonds. There is also no need to hold physical assets that require ongoing funding.

What are Mortgage-Backed Securities? 

At their core, MBS represent ownership interests in pools of mortgage loans. Financial institutions originate these loans, then bundle them together and sell them to investors. The resulting securities pay interest and principal to investors as borrowers make their mortgage repayments.

The market divides into two primary categories: Residential Mortgage-Backed Securities (RMBS) and Commercial Mortgage-Backed Securities (CMBS). While both follow similar securitisation principles, they differ in their underlying assets and risk characteristics.

RMBS: Investing in Home Loans 

RMBS consist of pools of residential mortgages – loans made to individuals purchasing homes. A typical RMBS structure contains hundreds or thousands of individual mortgages, with total pool values ranging from $500 million to $1 billion.

The payment structure of RMBS follows a “waterfall” model, with investors holding different classes or “tranches” of securities:

• Senior tranches (AAA-rated) receive payments first and have priority claim on cash flows.
• Mezzanine tranches (AA to BBB-rated) receive payments after senior tranches.
• Subordinate tranches rank below the other tranches and absorb initial losses that may arise. They offer higher yields to compensate for this risk.

This structure creates built-in credit enhancement for senior tranches, as lower tranches must absorb losses before senior investors experience any reduction in payments.

CMBS: Financing Income-Producing Properties 

CMBS differ from their residential counterparts by focusing on loans secured by commercial properties, for example: office buildings, shopping centres, hotels, industrial facilities, and apartment complexes. These properties generate rental income which supports loan payments.

The typical CMBS structure contains fewer loans than RMBS—often between 25 and 100 commercial mortgages bundled together. However, the loan size is typically significantly higher.

Like RMBS, CMBS use a tranche structure, but with some key differences:

• Super Senior (AAA) tranches sit at the top of the payment priority
• Junior Senior (AA to A) tranches follow
• Mezzanine (BBB) tranches occupy the middle risk spectrum
• Subordinate (BB and below) tranches absorb initial losses

Commercial loans often include significant balloon payments at maturity rather than fully amortising over the loan term. This creates refinancing risk that investors must evaluate when considering CMBS investments.

The Australian MBS Landscape 

Australia’s MBS market has distinctive characteristics which set it apart from other global markets. The Australian RMBS sector benefits from the country’s full-recourse lending system, where borrowers remain liable for loan balances even after property foreclosure. This feature has contributed to historically lower default rates.

The Australian CMBS market, while smaller than its residential counterpart, has shown steady growth since 2020. It typically features stronger covenant packages and higher debt service coverage ratios than comparable US securities. Major issuers include the big four banks and specialised non-bank lenders, with retail and office properties representing over 60 per cent of the underlying collateral. The Reserve Bank of Australia’s term funding facility has also influenced this market, periodically accepting certain RMBS as collateral and thereby enhancing their liquidity profile.

Key Metrics for Evaluating MBS 

Several critical measurements help investors assess MBS:

For RMBS:

• Loan-to-Value (LTV) ratio: The percentage of the property value represented by the loan amount
• Credit scores of borrowers: Higher scores generally indicate lower default risk
• Prepayment speeds: How quickly borrowers repay principal ahead of schedule

For CMBS:

• Debt Service Coverage Ratio (DSCR): The property’s net operating income divided by debt service requirements
• Loan-to-Value (LTV) ratio: The percentage of the commercial property value represented by the loan amount
• Property type and location: Different commercial sectors carry varying risk profiles

How RMBS and CMBS Differ 

While both security types provide real estate exposure, they differ in several important ways:

• Prepayment risk: RMBS generally face higher prepayment risk as homeowners can refinance without significant penalties. CMBS typically include prepayment protection through lockout periods or yield maintenance provisions.
• Cash flow sources: RMBS payments come from individual homeowners, while CMBS rely on rental income from commercial properties.
• Loan terms: Residential property loans are typically 15-30 years long and fully amortise. Commercial property loans are typically 5-10 years long with balloon payments due at maturity.
• Default recovery: Residential foreclosures typically recover 60-70% of loan value, while commercial recoveries vary widely based on property type and market conditions.

Benefits and Risks 

MBS offer several potential advantages for investors:

• Regular income streams from interest and principal payments
• Generally higher yields than similarly rated government or corporate bonds
• Diversification across multiple properties and geographic regions
• Ability to select risk levels through different tranches

However, these securities also present distinct risks:

• Credit risk if borrowers default on their mortgages
• Interest rate risk affecting both valuation and prepayment behaviour
• Liquidity constraints compared to Treasury bonds or blue-chip corporate debt
• Complexity requiring specialised knowledge to evaluate properly

Investors can access the MBS market through several channels:

• Exchange-traded funds (ETFs) focusing on MBS
• Mutual funds specialising in MBS investments
• Direct purchases of individual securities (typically requiring significant capital)
• Real estate investment trusts (REITs) that hold MBS as part of their portfolios.

For most individual investors, funds provide a practical entry point, offering professional management and diversification across multiple securities.

The MBS market continues to evolve, with innovations in structure and risk management. Understanding the fundamental differences between RMBS and CMBS provides a foundation for exploring this significant segment of the fixed-income universe.

To discover more call 1300 683 106 or email us on investordesk@nab.com.au

The information contained in this article is believed to be reliable as at April 2025 and is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. Before acting on this information, NAB recommends that you consider whether it is appropriate for your circumstances. NAB recommends that you seek independent legal, property, financial and taxation advice before acting on any information in this article.

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