Interest-Only/Principal-Only Mortgage-Backed Strips: A Valuation and Risk Analysis

Abstract:     
We examine the risk characteristics of each portion of IO/PO mortgage strips, present results of a valuation model of these securities, and examine market prices of both the interest-only and principal-only portions of mortgage pools. We show that IO/PO securities are highly sensitive to the prepayment behavior of the underlying mortgage pool. Because that behavior varies systematically with the interest rate, and because prepayments affect the values of I0 and PO components in opposite ways, the interest-rate risk of strip securities can differ substantially from that of the underlying mortgage pool. The PO component has much longer duration than the underlying mortgage pool. In contrast, the IO component typically will have a negative duration, at least in ranges for which interest-rate movements induce meaningful changes in mortgage prepayment behavior. We also show how market prices of partially-stripped MBSs that are actively traded on secondary markets can be used to infer market values of pure IO/PO strips. Recent market data is fully consistent with the theoretical insights offered by our valuation model. When interest rates spiked last April, PO values fell far more dramatically than those of the underlying mortgage pool while IO values actually rose.

Working Paper Series