The main advantage that collateralized mortgage obligations offer over other kinds of mortgage-backed pass-through securities is protection from the prepayment uncertainties caused by changing interest rates. With Ginnie Mae and Freddie Mac bonds, a drop in interest rates could cause the mortgage you bought to be paid off early, shortening the term of your investment and diminishing your overall yield. CMOs offer a degree of protection that makes the income they produce more reliable than returns from other pass-throughs. This protection is not iron-clad, however. Even a relatively low-risk PAC bond might suffer in the event that plunging interest rates cause a rush of mortgage prepayments.

CMO bonds typically receive AAA ratings, largely because they are based mostly on government-backed mortgages. Another advantage CMOs offer investors is a lower minimum cost to buy into the investment. It is possible to buy a CMO bond for as little as $1,000, compared with a $25,000 minimum for other newly issued pass-through securities.

Because of their relative safety from mortgage prepayment, CMOs tend to offer lower yields than other pass-through securities. However, they still tend to perform better than other kinds of fixed-income securities such as U.S. Treasury bonds. And default risk is low: CMO bonds typically receive AAA ratings, largely because they are based mostly on government-backed mortgages.

While returns from CMOs are taxed as regular income, it is possible to include these instruments in tax-deferred retirement accounts. Also, as with most fixed-income securities, CMOs offer little protection against the detrimental effects of inflation.

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