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Interest Rates and Yields on CMOs

The interest rates paid on CMOs will be lower than the interest rates paid on the underlying mortgage loans, because the issuer retains a portion of the interest paid by the mortgage borrower as a “servicing fee” for creating the security and for collecting and distributing the monthly payments to investors. Still, newly issued mortgage securities carry higher estimated yields than comparable Treasury securities. In part, this is because the interest rates paid by home buyers are higher than the interest rates paid by the U.S. government. However, the higher interest rates on mortgage securities also reflect compensation for the uncertainty of their average lives.


Because CMOs pay monthly or quarterly, as opposed to the semiannual interest payment schedule for most bonds, CMO investors can use their interest income much earlier than other bond investors. Therefore, CMOs are often discussed in terms of their “bond equivalent yield,” which is the actual CMO yield adjusted to account for its greater present value resulting from more frequent interest payments.

