Suppose you are told that the cash flow yield of a pass-through security is 9% and that you are seeking to invest in a security with a yield greater than 8.8%.Answer the below questions

What additional information would you need to know before you might invest in this pass-through security?

To determine your chances of actually getting an 8.8% return, you would want to know the types of securities backing the pass-through, the safety of the cash flows, and the expected volatility of the cash flows. More details are given below.

A mortgage pass-through security consists of a set of marketable shares in a portfolio of mortgages for which investors receive monthly payments of both interest and principal. Normally the package is secured by credit insurance so that investors are protected from the credit risks of the individual mortgages in the portfolio. However, no protection is provided against the cash flow and return volatility associated with unanticipated principal prepayments, which typically occur when interest rates drop and homeowners refinance their mortgages.A conventional pass-through is a mortgage pass-through security that is not guaranteed by a government agency.

If applicable, you would want to know the prepayment rate for a particular tranche formed from the pass-through security as well as any stipulated guarantees in terms of interest and principal payments. One should note that the greater the discount assumed to be paid for a tranche, the more a tranche will benefit from faster prepayments. The converse is true for a tranche for which a premium is paid. The faster the prepayments, the lower the cash flow yields.

The above factors along with an expected reinvestment rate will give you an idea as to whether or not the 9% return will be realized.