Principal Only Strips - PO

DEFINITION of 'Principal Only Strips - PO'

A type of fixed-income security where the holder is only entitled to receive regular cash flows that are derived from incoming principal repayments on an underlying loan pool. The loan is often a pool of mortgages in the form of a mortgage-backed security (MBS).

BREAKING DOWN 'Principal Only Strips - PO'

This security is created by splitting a mortgage-backed security into its interest and principal payments. The principal payments create a string of cash flows which are sold at a discount to investors. These investors will receive the principal portions of the monthly mortgage payments from the underlying pool of loans.

The yield on a PO strip depends on the prepayment speed of the underlying loan. The faster the principal is repaid, the higher the yield an investor will receive. Since the investor benefits from faster repayment speeds, he or she is protected from contraction risk. This means that, unlike a usual bond, the investor will benefit from decreases in the interest rate.

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