Mortgage-backed securities are created when a mortgage provider, such as a savings association, commercial bank or mortgage company, sells its residential loans to a federally sponsored credit agency or a private institution. The three federally sponsored agencies which issue mortgage-backed securities are:

• Government National Mortgage Association (GNMA)
• Federal National Mortgage Association (FNMA)
• Federal Home Loan Mortgage Corporation (FHLMC)

Mortgage-backed securities offer the investor:

• Credit Quality - GNMA principal and interest payments are backed by the full faith and credit of the U.S. government. FNMA and FHLMC, while not direct obligations, are government sponsored enterprise obligations.
• Monthly Income - Interest as well as partial return of principal are payable to mortgage-securities investors on a monthly basis.
• Yield - Historically, mortgage pass through securities have offered higher yields than U.S. Treasury issues with comparable maturities.
• Liquidity - A large and active secondary market provides liquidity at prices subject to prevailing market conditions.

How They Work
The agency or private company "pool" mortgages together and issue what are known as mortgage pass-through certificates, with underlying mortgage loans as collateral. When a homeowner makes a monthly mortgage payment, this payment is "passed-through" to the mortgage security holder.

Fixed income securities are subject to market risk and interest rate risk. If sold in the secondary market prior to maturity, investors may experience a gain or loss depending on interest rates, market conditions and the credit quality of the issuer.

Prepayment Risk - Changes in the prepayment speeds of the underlying mortgages will have a direct impact on the maturity structure of the pass-through security. An increase in prepayment speeds will lead to acceleration in principal returns and a contraction in the average life. A drop in prepayments, on the other hand, will lead to a slow down in principal returns and an extension in the average life.

Interest Rate Risk - Like any other fixed-income instrument, mortgage pass-through securities bear exposure to interest rate risk. For example, if principal returns on a mortgage security accelerate because interest rates are trending downward, the average life will contract and interest payments will be received over a shorter period of time. Conversely, if interest rates increase, return of principal can decelerate, causing the security's average life to extend. In either case, changes in the level of interest rates can directly affect a mortgage security's market value and total return.

Spread Risk - The yield spreads between Treasury and mortgage securities fluctuate on a daily basis. If the yield spread on a mortgage security widens versus Treasuries, an investor seeking to liquidate a position could suffer a capital loss, even if the Treasury market is virtually unchanged.

UBS Financial Services Inc. does not provide tax or legal advice.  Please contact your tax advisor regarding the suitability of these investments in your portfolio.