Mortgage backed securities can be stripped into principal only (PO) strips and interest only (IO) strips. The principal component of the MBS payment is used to pay down the PO strip MBS, while the interest component of the payment is used to pay the IO strip MBS.
The bonds of stripped MBS therefore do not have a pro-rata principal and interest payment distribution to investors.
PO strips receive the entire mortgage principal and only the mortgage principal.
- PO strips have a known dollar amount but an unknown timing.
- The PO strip will be sold to investors at a significant discount to the gross principal balance; the discount amount will be based on the level of interest rates and the prepayment speed.
- Generally, PO strip bonds are more volatile than conventional MBS.
- Declining interest rates increase PO repayment speed, lowering the discount rate and increasing the PO price.
- Rising interest rates cause prepayments to decelerate and increases the discount rate applied to cash flows, thus lowering the PO price.
- The yield on PO strips varies based on the prepayment speed. The higher the prepayment, the faster the principal is repaid, and the higher is the yield for the investors.
- The investor is protect from the contraction risk.
IO strip investors receive only the interest component of the mortgages in the security pool.
- Assuming that a mortgage is held to maturity, the IO payments would be very high in the early years and very low in the later years.
- High prepayments tend to reduce IO values.
- As interest rates decline and prepayments increase, less dollars of interest are paid to IO investors, so IO prices can drop when interest rates decline.
- As interest rates increase, prepayments decrease, so mortgages last longer and the total dollars paid to IO holders rises; therefore IO prices can rise when interest rates rise.