Interest-Only and Principal-Only Strips
Splitting a mortgage pool's cash flows into an interest-only piece and a principal-only piece creates two securities with opposite reactions to prepayment speed, even though together they add up to exactly the same pool.
Prerequisites: The PSA Prepayment Benchmark and SMM, Prepayment S-Curves and Refinancing Incentive
A mortgage pass-through pays two kinds of cash flow every month: interest on the outstanding balance, and principal (scheduled plus prepaid). Instead of selling investors the combined stream, an issuer can strip the two apart into separate securities — an interest-only (IO) strip that receives only the interest cash flows, and a principal-only (PO) strip that receives only the principal cash flows. Together they reconstruct the original pool exactly, but held separately they are two of the most differently-behaved securities in fixed income.
A PO strip is bought at a discount to its face value and is worth more the faster the pool prepays, because prepayment simply returns that face value sooner. An IO strip has no face value to be returned at all — its only cash flow is interest on a shrinking balance, so faster prepayment destroys its value by shrinking the balance interest is paid on.
Why they move in opposite directions
A PO strip is purchased for less than the dollar amount of principal it will eventually receive — the discount is the investor's return, realized whenever that principal actually comes back, whether on schedule or early via prepayment. Since a dollar returned sooner is worth more than a dollar returned later, anything that speeds up prepayment (falling rates, high refinancing incentive) makes a PO strip more valuable. An IO strip owns no principal claim at all; its cash flow each month is simply the pool's remaining balance times the coupon rate. The moment a loan prepays, its balance leaves the interest-generating pool entirely, and the IO holder loses that stream of interest permanently. Falling rates that trigger heavy prepayment are the single worst outcome for an IO holder.
Worked example
A $100 face value PO strip is bought for $72. If the pool prepays quickly and that $100 of principal comes back in 3 years instead of an originally expected 7, the investor's realized yield rises substantially, since the same $28 discount is earned over a shorter holding period. An IO strip on a similarly-sized pool paying 6% interest generates roughly $6 a year in interest while the pool balance stays near $100. If heavy prepayment cuts the remaining balance to $40 within three years instead of the seven originally projected, the IO holder's interest income falls to roughly $2.40 a year on that reduced balance years earlier than expected, and the strip's remaining value drops sharply.
What this means in practice
IO and PO strips are used less as standalone investments and more as hedging tools: a portfolio manager holding a large book of premium mortgage bonds — which lose value when prepayment accelerates — can buy IO strips (which also lose value under fast prepayment, in the same direction) as a targeted way to add prepayment-speed exposure, or use PO strips to offset it, without having to trade the underlying pools themselves.
IO strips can go to a near-total loss of remaining value if rates fall far enough to trigger very fast prepayment, even though the pool experienced zero credit losses — the entire loss is a mechanical consequence of the interest-earning balance disappearing, not of any borrower defaulting.
Related concepts
Practice in interviews
Further reading
- Fabozzi, The Handbook of Mortgage-Backed Securities