Principal only strip

What Is a Principal Only Strip?

A principal only strip (PO strip) is a type of fixed income securities that represents solely the principal payments from a pool of underlying debt instruments. Unlike traditional bonds that pay both interest and principal, a PO strip entitles its holder to receive only the future principal repayments of the debt, with no entitlement to the interest payments. These securities are commonly created from mortgage-backed securities (MBS) or U.S. Treasury bonds through a process called "stripping." The investor purchases a PO strip at a discount to its face value, with the return generated from the difference between the purchase price and the full principal amount received at maturity or upon prepayment. PO strips are particularly sensitive to changes in interest rates and prepayment risk.

History and Origin

The concept of stripping debt instruments emerged in the U.S. financial markets to allow investors to tailor their exposure to specific cash flows. The formal program for stripping U.S. Treasury securities, known as Separate Trading of Registered Interest and Principal of Securities (STRIPS), was initiated by the U.S. Treasury in 1985. This program enabled financial institutions to separate the individual interest and principal components of eligible Treasury notes, bonds, and Treasury Inflation-Protected Securities (TIPS) into distinct zero-coupon securities.⁴

Shortly after, the market for stripped mortgage-backed securities began to develop. For instance, the Federal National Mortgage Association (Fannie Mae) started creating similar stripped products from mortgage pools.³ This innovation provided investors with instruments that offered cash flow patterns different from the underlying whole bond or mortgage pool, leading to diverse investment strategies.

Key Takeaways

A Principal Only (PO) strip is a financial instrument that provides investors with only the principal payments from an underlying debt obligation.
These securities are created by separating, or "stripping," the principal component from the interest component of a traditional bond or pooled security like a mortgage-backed security.
PO strips are purchased at a discount to their face value and mature at par, with the return derived from this appreciation.
Their value is highly sensitive to changes in interest rates and the prepayment speed of the underlying loans, particularly in the case of mortgage-backed PO strips.
Investors typically use PO strips to express a specific outlook on interest rate movements, benefiting when interest rates fall and prepayments accelerate.

Formula and Calculation

A principal only strip does not have a single, universal "formula" in the way a bond's coupon is calculated. Instead, its valuation is based on the present value of its expected future principal cash flows. The return to the investor is realized as the difference between the discounted purchase price and the full principal amount received at maturity or upon earlier prepayment. The expected cash flows (principal repayments) will be discounted back to the present using an appropriate discount rate that reflects the prevailing market yield for such a security.

The present value ((PV)) of a PO strip can be conceptualized as:

PV = \sum_{t=1}^{N} \frac{P_t}{(1+r)^t}

Where:

(P_t) = Principal payment received at time (t)
(r) = Discount rate (market yield to maturity for the PO strip)
(N) = Total number of principal payments or the strip's effective maturity

In practice, for mortgage-backed PO strips, (P_t) is not fixed and depends heavily on the actual cash flow of the underlying mortgage-backed securities pool, specifically how quickly borrowers prepay their mortgages. For Treasury PO strips, (P_t) is a single, known principal payment at maturity, making their valuation more straightforward, similar to a zero-coupon bond.

Interpreting the Principal Only Strip

Interpreting a principal only strip primarily involves understanding its sensitivity to interest rates and prepayment speeds. For PO strips derived from mortgages, a decline in interest rates typically leads to an increase in mortgage prepayments (as borrowers refinance at lower rates). This accelerated return of principal is generally beneficial to PO strip holders, as they receive their principal more quickly, increasing their effective yield. Conversely, if interest rates rise, prepayments tend to slow down, extending the duration of the PO strip and potentially diminishing its value. This inverse relationship between interest rates and prepayment speeds makes PO strips a highly specialized investment.

For Treasury PO strips, the relationship is more direct: as interest rates fall, the present value of the fixed future principal payment rises, increasing the PO strip's price. When interest rates rise, the price of the PO strip falls. This makes them highly sensitive to interest rate fluctuations, often exhibiting a longer duration than the original bond from which they were created. Investors must consider their outlook on interest rates and the potential for prepayment risk when evaluating PO strips.

Hypothetical Example

Consider an investor, Sarah, who believes interest rates are likely to fall significantly in the coming years. She decides to invest in a mortgage-backed principal only strip.

The PO strip has a notional principal of $100,000 and is currently trading at a discounted price of $75,000. It is backed by a pool of 30-year fixed-rate mortgages.

Scenario 1: Interest rates fall.
As interest rates decline, many homeowners in the underlying mortgage pool choose to refinance their mortgages to lock in lower rates. This leads to an acceleration of principal repayments to the PO strip. Instead of receiving principal payments slowly over 30 years, Sarah begins receiving larger and faster principal payments. If the entire $100,000 notional principal is repaid faster than originally anticipated, say in 10 years instead of 30, Sarah's effective yield on her initial $75,000 investment increases significantly because she receives her full principal return much sooner.

Scenario 2: Interest rates rise.
If interest rates were to rise, homeowners would have less incentive to refinance. Prepayments would slow down considerably, meaning Sarah would receive her principal payments much more slowly, potentially extending the effective maturity of her investment. This would likely cause the market value of her PO strip to decrease, as the present value of distant future cash flows is lower. This illustrates the inherent volatility of PO strips when interest rates move unfavorably.

Practical Applications

Principal only strips serve niche purposes within the broader fixed income market, primarily for investors with strong convictions about future interest rate movements and prepayment trends.

Interest Rate Speculation: Investors anticipating a decline in interest rates may purchase mortgage-backed PO strips. The expectation is that falling rates will lead to increased mortgage refinancings, accelerating the receipt of principal payments and enhancing the investor's return. Conversely, investors might sell PO strips if they expect rates to rise.
Hedging Strategies: While complex, some sophisticated investors might use PO strips as part of a hedging strategy to offset other interest-rate sensitive positions in their portfolios. For example, the unique duration characteristics of a PO strip can sometimes complement other securities.
Asset-Liability Management (ALM): Financial institutions sometimes use PO strips in their ALM strategies to match specific long-term liabilities. For instance, an institution might purchase Treasury PO strips to guarantee a lump-sum payment on a specific future date, like a pension obligation or a large contractual payout. These securities offer a predictable future payment without the reinvestment risk associated with periodic coupon payments from traditional Treasury bonds.

PO strips are components of complex structured products such as collateralized mortgage obligations (CMOs), where various tranches are created with different cash flow characteristics.²

Limitations and Criticisms

Principal only strips, especially those derived from mortgage-backed securities, come with significant limitations and risks that make them unsuitable for many investors.

High Interest Rate Sensitivity: PO strips are highly sensitive to interest rate fluctuations. For mortgage-backed PO strips, a rise in interest rates can dramatically reduce their value because it slows down the rate of mortgage prepayments, stretching out the receipt of principal payments over a longer period. This extended effective maturity makes the investment less attractive. Conversely, while falling rates can increase value, the extreme sensitivity means prices can fluctuate wildly.¹
Prepayment Risk: This is the primary risk for mortgage-backed PO strips. The timing of principal payments is uncertain as it depends on how quickly underlying mortgages are paid off. Factors like falling interest rates (leading to refinancing), home sales, and borrower defaults can all accelerate or decelerate prepayments, making cash flow unpredictable.
Phantom Income (for Treasury STRIPS): While Treasury PO strips (a form of zero-coupon bond) do not pay periodic interest, investors are still required to pay taxes annually on the "imputed interest" or "original issue discount" as it accrues, even though no cash is received until maturity. This can create a tax liability without a corresponding cash inflow, a concept known as "phantom income."
Liquidity Risk: Depending on the underlying collateral and market conditions, PO strips can be less liquid than more traditional fixed-income investments, making them difficult to sell quickly at a fair price before maturity.
Complexity: The valuation and behavior of PO strips, especially those from MBS, are complex and require a deep understanding of fixed-income analytics and prepayment models, which can be challenging for average investors.

Principal Only Strip vs. Interest Only Strip

A principal only strip (PO strip) and an interest only strip (IO strip) are both types of stripped securities, meaning they separate the income streams of an underlying debt instrument. However, they represent opposite claims to the cash flows and exhibit fundamentally different sensitivities to interest rate changes and prepayment behavior.

Feature	Principal Only (PO) Strip	Interest Only (IO) Strip
Cash Flow	Receives only the principal payments.	Receives only the interest payments.
Purchase Price	Purchased at a discount to its face value.	Purchased at a small fraction of its notional value.
Maturity Payout	Receives full face value at maturity/prepayment.	Becomes worthless at maturity or when principal is repaid.
Interest Rate Sensitivity	Value generally increases when interest rates fall (due to accelerated prepayments). Value decreases when rates rise (slowed prepayments).	Value generally increases when interest rates rise (slower prepayments mean more interest payments over time). Value decreases when rates fall (accelerated prepayments reduce total interest received).
Prepayment Risk	Benefits from faster prepayments.	Negatively impacted by faster prepayments.
Relationship to Underlying	Has a longer duration than the underlying bond (for MBS).	Can have negative duration (for MBS).

The key source of confusion often stems from their opposing reactions to changes in interest rates. A PO strip benefits from falling rates because it accelerates the return of principal, while an IO strip benefits from rising rates because it extends the period over which interest payments are received. Investors choose between PO and IO strips based on their specific market outlook and their desire for distinct cash flow characteristics.

FAQs

How does a principal only strip generate returns?

A principal only strip generates returns from the appreciation of its price. It is purchased at a discount to its face value, and the investor receives the full principal amount at maturity or when the underlying debt is prepaid. The difference between the purchase price and the amount received is the profit.

Are principal only strips guaranteed?

U.S. Treasury principal only strips (Treasury STRIPS) are backed by the full faith and credit of the U.S. government, making them virtually free of default risk. However, PO strips derived from mortgage-backed securities or other asset-backed securities carry credit risk related to the underlying loans and the issuer. None offer a guaranteed return or protection against market price fluctuations due to interest rate changes or prepayments.

Can principal only strips lose money?

Yes, principal only strips can lose money. If you sell a PO strip before its maturity, its market price may be lower than your purchase price, especially if interest rates have risen or prepayment speeds have significantly slowed down (for MBS-backed PO strips).

Who typically invests in principal only strips?

Principal only strips are typically favored by institutional investors, money managers, and sophisticated individual investors who have a specific outlook on future interest rates and prepayment trends. They are often used for precise asset-liability matching or for speculative purposes within specialized fixed income portfolios.