Interest only strip

An interest only strip (IO strip) is a type of Mortgage-backed securities (MBS) or Collateralized mortgage obligations (CMO) that entitles its holder to receive only the interest payments from a pool of underlying mortgages or other debt instruments. Unlike a traditional bond, an investor holding an interest only strip does not receive any portion of the principal payments; those are allocated to a different class of investors. This unique structure makes the cash flow from an interest only strip highly sensitive to changes in interest rates and borrower prepayment behavior. It is a specialized product within the broader category of Fixed income securities, designed for investors with specific market expectations. The value of an interest only strip is derived from the future Cash flow of interest payments.

History and Origin

The concept of "stripping" the principal and interest components of a debt instrument emerged in the financial markets to cater to diverse investor needs and risk appetites. While Treasury strips, which separate interest and principal payments of U.S. Treasury bonds, were introduced by the U.S. Treasury in the mid-1980s, the application of this concept to mortgage-backed securities followed. Collateralized mortgage obligations (CMOs), which allowed for the creation of multiple classes or Tranches from a pool of mortgages, paved the way for more complex structures like interest only strips. The Financial Industry Regulatory Authority (FINRA) provides information on the structure of CMOs, including how principal and interest payments are distributed among different tranches.⁵ These innovations in Securitization allowed financial institutions to transform less liquid assets into more marketable securities, enabling a broader range of investors to participate in the mortgage market.

Key Takeaways

• An interest only strip grants the investor rights to receive only the interest payments from an underlying pool of debt, typically mortgages.
• The value of an interest only strip is highly susceptible to changes in interest rates, as these changes directly influence borrower prepayment speeds.
• Holders of interest only strips generally benefit when interest rates rise, as this tends to slow down mortgage prepayments, ensuring a longer stream of interest income.
• Conversely, a decrease in interest rates often leads to increased mortgage prepayments, which can significantly reduce the value and expected cash flow of an interest only strip.
• Interest only strips are often used by investors for hedging against interest rate risk or for speculative purposes based on interest rate forecasts.

Interpreting the Interest Only Strip

Understanding an interest only strip involves appreciating its unique sensitivity to market conditions, particularly interest rates and prepayment speeds. Unlike traditional bonds, an interest only strip's value moves inversely with the rate of prepayments on its underlying mortgages. When interest rates fall, homeowners are more likely to refinance their mortgages at a lower rate, leading to faster Principal payments on the underlying loans. This early repayment means the total amount of interest paid over the life of the loan decreases, reducing the expected cash flows to the holder of the interest only strip. This phenomenon is known as Prepayment risk.⁴

Conversely, when interest rates rise, homeowners are less likely to refinance, which slows down prepayments. This extended life of the underlying mortgages means more interest payments accrue over time, benefiting the interest only strip holder. Therefore, an interest only strip can exhibit negative Duration and positive Convexity characteristics relative to interest rates, making it a valuable tool for hedging against Interest rate risk in a portfolio of traditional fixed-income securities. The shape of the Yield curve also plays a role in how these securities are valued and how their cash flows are interpreted.

Hypothetical Example

Imagine a pool of mortgages with an average remaining balance of $100 million and a weighted average coupon rate of 5%. An investor purchases an interest only strip backed by this pool.

• Scenario 1: Interest rates rise. If market interest rates increase, say to 6%, homeowners with 5% mortgages are less likely to refinance. Prepayments on the underlying mortgages slow down considerably. As a result, the pool of mortgages remains outstanding for a longer period, generating a steady stream of interest payments for the interest only strip holder for an extended duration. The value of the interest only strip would likely increase in this scenario due to the prolonged collection of interest.

• Scenario 2: Interest rates fall. If market interest rates drop, say to 3%, many homeowners with 5% mortgages will likely refinance to take advantage of the lower rates. This leads to a rapid increase in prepayments on the underlying mortgages. For the interest only strip holder, this means their stream of future interest payments is cut short. The early repayment of principal by borrowers reduces the notional principal on which interest is calculated, significantly decreasing the total interest received and thereby diminishing the value of the interest only strip.

This example illustrates how the performance of an interest only strip is intimately tied to prepayment speeds, which are heavily influenced by prevailing interest rates.

Practical Applications

Interest only strips are used in various practical applications within the financial markets:

• Hedging Interest Rate Risk: Portfolio managers often use interest only strips to hedge against Interest rate risk in portfolios dominated by traditional fixed-income securities. Since the value of an interest only strip tends to increase when interest rates rise (and prepayments slow), it can offset losses incurred by other bonds whose values fall as rates increase. This counter-intuitive relationship helps balance overall portfolio sensitivity.
• Speculation on Interest Rates: Traders and speculative investors may buy or sell interest only strips based on their outlook for future interest rates. An investor anticipating rising rates might purchase an interest only strip, while one expecting falling rates might short it or avoid it.
• Structured Finance Products: Interest only strips can be components within more complex Collateralized mortgage obligations (CMOs) or other structured products, where they are used to create tailored cash flow profiles for different investor needs.
• Asset-Liability Management: Financial institutions may use interest only strips as part of their asset-liability management strategies to manage mismatches between the duration of their assets and liabilities.
• Valuation Modeling: The valuation of an interest only strip involves sophisticated financial modeling that considers expected prepayment rates, future interest rate scenarios, and the appropriate Discount rate to calculate the Net present value of future interest cash flows. The Federal Reserve highlights the significant role mortgage-backed securities play in financial markets and their impact on monetary policy through their holdings.³

Limitations and Criticisms

Despite their utility, interest only strips carry significant limitations and criticisms, primarily due to their inherent complexities and high sensitivity to market dynamics.

• High Prepayment Risk: The most notable limitation is their acute exposure to Prepayment risk. When interest rates decline, homeowners aggressively refinance their mortgages, leading to a rapid reduction in the outstanding principal balance and, consequently, the interest payments received by IO strip holders. This can result in substantial losses for investors, potentially even leading to a complete loss of the investment if prepayments are extremely rapid.²
• Interest Rate Sensitivity: The value of an interest only strip is exceptionally sensitive to interest rate movements, often exhibiting negative Duration. This means its price can fall when interest rates decline, contrary to most fixed income securities. This characteristic, while useful for hedging, makes it a highly volatile investment if not managed carefully.
• Modeling Complexity: Accurately forecasting the cash flows from an interest only strip requires sophisticated prepayment models and interest rate scenarios. These models are complex and rely on numerous assumptions, which may not always hold true in real-world market conditions. Errors in these assumptions can lead to significant mispricing and unexpected losses.
• Liquidity Concerns: While the broader mortgage-backed securities market is generally liquid, specific or thinly traded interest only strip tranches might suffer from lower liquidity, making them difficult to buy or sell quickly without impacting their price.
• Reinvestment Risk: Should prepayments occur rapidly, the investor receives cash earlier than expected. This introduces Reinvestment risk, particularly if interest rates have fallen, as the investor may be forced to reinvest the returned capital at lower prevailing rates, reducing overall returns.
• Default risk: While many IO strips are based on agency-backed mortgages which mitigate credit risk, non-agency IO strips or those based on other forms of debt can carry significant credit or default risk from the underlying borrowers. Reuters explains that MBS, generally, carry prepayment risk, but can also be exposed to market and liquidity risks.

Interest Only Strip vs. Principal Only Strip

The interest only strip and the Principal only strip are two distinct components created by separating the cash flows of a bond or mortgage-backed security. They represent opposite sides of the same coin in terms of their sensitivity to interest rates and prepayment speeds.

The core confusion arises because both are "stripped" securities, but their valuation drivers are diametrically opposed. While an interest only strip profits from prolonged interest payments, a principal only strip benefits from the rapid return of principal, which occurs when borrowers refinance. This inverse relationship makes them potential hedges for one another or tools for highly specific interest rate bets.

FAQs

What is the primary risk of an interest only strip?

The main risk of an interest only strip is Prepayment risk. If interest rates fall, borrowers refinance their mortgages more quickly, reducing the pool's outstanding principal and cutting short the stream of interest payments for the IO strip holder, potentially leading to losses.¹

How does an interest only strip react to rising interest rates?

When interest rates rise, homeowners are less likely to refinance their existing mortgages. This means the underlying mortgages stay outstanding for longer, ensuring a more prolonged stream of interest payments for the interest only strip holder. Consequently, the value of an interest only strip tends to increase in a rising interest rate environment.

Can an interest only strip be used for hedging?

Yes, an interest only strip can be an effective tool for hedging Interest rate risk. Because its value typically moves inversely to traditional bonds in response to interest rate changes (i.e., it gains value when rates rise), it can help offset potential losses on a bond portfolio during periods of increasing interest rates.

Are interest only strips suitable for all investors?

No, interest only strips are generally not suitable for all investors due to their complex nature and high sensitivity to interest rate and prepayment risks. They are best suited for sophisticated investors with a clear understanding of Mortgage-backed securities and a specific outlook on interest rate movements.

What happens to an interest only strip if all underlying mortgages default?

If all underlying mortgages were to default, the interest only strip holder would cease to receive interest payments. While many IO strips are backed by government-guaranteed mortgages, reducing credit risk, non-guaranteed IO strips would be exposed to significant Default risk, potentially leading to a total loss of investment.