Interest Only (IO) Strips
What Are Interest Only Strips?
In some cases investment firms or dealers take a debt obligation or pool of obligations — mortgages, Treasury bonds, or different bonds — and subsequent to isolating their principal and interest portions, sell them as distinct security products to investors, hence making what's known as a strip bond. An interest only strip is one of these separated securities — the part that comprises only of the interest portion of the regularly scheduled payments.
Despite the fact that interest only strips can be made out of any debt-backed security that generates periodic payments, the term is generally associated with mortgage-backed securities (MBS).
How Interest Only Strips Work
The most common way of isolating the principal and interest on a debt obligation is known as stripping. A mortgage-backed security (MBS) that goes through this interaction — isolating the interest and principal payment streams — is alluded to as stripped MBS.
The other half of the stripped security — the portion that isn't the interest only strip — is known as a principal only (PO) strip. Investors who buy principal only strips receive the portion of the regularly scheduled payment from the underlying mortgage pool that is applied to the balance of the loan.
Since the underlying assets in a MBS are mortgages, the interest only strip functions like the interest payment portion of a mortgage. Interest is the greater portion of a mortgage payment in the early long stretches of the mortgage. In later years, the interest-payment portion decreases as a greater amount of the payment goes to the principal. Simultaneously, investors receive more modest payments from interest-only strips as they approach the finish of the mortgage period.
Interest Rate Considerations
Interest only strips were made to appeal to investors with a particular perspective on the interest rate environment. All debt obligations are sensitive to changes in the interest rate environment yet mortgages are particularly sensitive. At the point when interest rates drop, borrowers have both the option (and an incentive) to refinance their mortgages at the current, lower interest rate. This prompts prepayment risk for investors who are holders of the interest only strips of a stripped MBS. If prepayment somehow happened to happen, investors would relinquish future interest payments and don't receive anything from the return of the principal.
Notwithstanding, when the prepayment rate on the underlying debt is low and interest rates are rising, investors who are holders of interest only strips are in the position to benefit since, figuring they have the best deal accessible, this sort of interest rate environment urges borrowers to hang onto their current mortgages.
With a complete MBS or a bond, the holder generally maintains that the payments should happen as arranged over the life of the investment. In any case, a stripped product presents various longings in regards to the performance of the underlying debt relying upon the portion of the security that the investor holds.
While the interest only strip holders need to see rising rates and no prepayment, principal only strip holders invite prepayment actions and the lowering interest rates that expeditious borrowers to refinance. In practice, investors generally don't make a binary play on interest or principal only strips, however build holdings that have a bias toward either without leaving the downside completely unhedged.
Special Considerations
The Role of Stripped Payments in Financial Valuation
Financial engineers, like Wall Street dealers, often strip and restructure bond payments with an end goal to earn arbitrage profits. For instance, the periodic payments of several bonds can be stripped to form synthetic zero-coupon bonds. Zero-coupon Treasury strips are an important building block in numerous financial calculations and bond valuations. The zero-coupon or spot-rate Treasury yield curve is utilized in option-adjusted spread (OAS) calculations and for different valuations of bonds with embedded options.
In addition, an interest strip can be reintegrated into other synthetic products. For instance, interest only strips can be pooled to make or make up a portion of a bigger collateralized mortgage obligation (CMO), asset-backed security (ABS) or collateralized debt obligation (CDO) structure.
Features
- The investor in the interest only strip benefits when interest rates are rising: Borrowers tend not to prepay or refinance their mortgages in such environments, so the income stream from the IO strip remains predictable.
- Interest only (IO) strips are a financial product made by isolating the interest and principal payments of a debt-backed security. The IO strip addresses the interest stream.
- While they can be made out of any loan, bond, or debt pools, IO strips are normally associated with mortgage-backed securities (MBS).
