What is a key disadvantage associated with MBS?

The key disadvantage associated with mortgage-backed securities (MBS) relates to the fact that borrowers have the option to make prepayments on their loans. When borrowers prepay, it affects the expected cash flow for investors in the MBS. This can create uncertainty regarding when the cash will be returned to the investor, as they may receive their principal back sooner than anticipated.

This prepayment risk can be particularly significant when interest rates decline. Homeowners are more likely to refinance their mortgages to take advantage of lower rates, leading to increased prepayments. For investors, this can disrupt their expected income stream and may force them to reinvest the proceeds in an environment with lower yields, potentially diminishing their returns.

While the other choices discuss relevant issues regarding MBS, they do not capture the unique challenge that prepayment risk presents for the cash flow management of investors in these securities.