A pass-through certificate is an investment that receives income from another form, often a pool of mortgages, with income passed through to the certificate holders.
A pass-through certificate is an investment vehicle representing an ownership interest in a pool of income-generating assets, such as mortgages. The income generated by these assets is collected and passed directly through to the holders of the certificates. This type of financial instrument is commonly used in the realm of mortgage-backed securities (MBS).
A pass-through certificate typically involves a pool of mortgages. The mortgage payments made by borrowers — including principal and interest — are aggregated into this pool. Financial entities securitize these pools and issue certificates of equal face amounts, essentially fractional ownership of the total pool.
The income from the underlying mortgage pool is collected by a servicer and “passed through” to the certificate holders. This occurs after subtracting any servicing fees or other associated costs. The pass-through method ensures that the cash flows from the mortgage pool directly benefit the holders of the certificates.
Consider a mortgage pool that generates monthly payments. If the pool has 100 mortgages, each generating $1,000 per month:
An investor holding a 1% interest in the pool would receive $950 monthly.
Pass-through certificates originated as part of the development of mortgage-backed securities in the 1970s. They were designed to attract investment in the mortgage market by providing a mechanism for distributing mortgage income directly to investors.
Over the decades, the structure of pass-through certificates has evolved with varying degrees of complexity, including collateralized mortgage obligations (CMOs) and real estate mortgage investment conduits (REMICs).
Pass-through certificates are most commonly associated with MBS, but the concept can be extended to other types of asset-backed securities (ABS), such as auto loans or credit card receivables.
These certificates can be part of a diversified investment strategy, providing relatively stable income streams. They are particularly appealing to investors seeking exposure to the real estate market without directly owning property.