The mortgage-backed securities (MBS) were the result of financial innovation at investment banks to meet the growing needs to the investors in the fixed income market. As we know, mortgage backed securities are a type of asset-backed securities in which the cash flows to the investors are provided from the cash flows from the underlying mortgage loans.
There are many types of MBS. One such type is the Stripped MBS. In a stripped MBS, the fully amortizing mortgage payments are stripped into its interest and principal components. Then using these cash flows two separate classes of securities are created called Interest Only (IO) strip and Principal Only (PO) strip. The principal component of the mortgage payment is used to pay down the PO strip and the interest component is used to pay down the IO strip. These securities are characterized by extremely unequal distribution of interest and principal cash flows. Both securities are sold to different investors requiring different risk exposure.
Let’s look at some of the characteristics of Interest-only Stripped Mortgage-backed Securities:
- They are characterized by high yields and are highly sensitive to changes in interest rates.
- The value of IO strip is calculated as the present value of expected interest cash flow to be received. The price is generally expressed as a % of notional principal of mortgage collateral. The price depends on the amount of interest cash flow and its time, both of which are uncertain.
- If market interest rates increase, prepayment of principal reduces. Therefore greater interest cash flow occurs. For this reason, IOs have attractive ‘bearish’ return feature. Alternatively, if interest rates fall, prepayments increase, which results in a fall in interest cash flow, as the interest is now collected on reduced principal balance.
- If the market interest rates fall below coupon, the price of IO strip falls, breaking the conventional price-yield inverse relationship. The price yield curve for IOs is upward sloping. In such a situation, the IO strip exhibits negative duration and convexity. This happens because the discount effect and prepayment effect move in opposite direction and the movement is dominated by prepayment effect.
- If the market interest rates are above the coupon, the price-yield curve is downward sloping just like for other bonds. The duration and convexity is positive. This happens because the discount effect and prepayment effect move in opposite direction and the movement is dominated by discount effect.
Even though IO strips provide high yield to investors, they are considered very risky because they are extremely sensitive to changes in prepayment rates and interest rates.