DEFINITION of 'Stripped MBS'

A trust comprised of mortgage-backed securities which are split into principal-only strips and interest-only strips. Stripped MBS derive their cash flows either from principal payments or interest payments on the underlying mortgages, unlike conventional MBS where cash flows are based on both principal and interest payments. Stripped MBS are very sensitive to interest rate changes.

BREAKING DOWN 'Stripped MBS'

There are some fundamental differences between principal-only strips and interest-only strips. Principal-only strips consist of a known dollar amount, but the payment timing is unknown. They are sold to investors at a discount - which is based on interest rates and prepayment speed - on face value. Interest-only strips generate high levels of cash flow in the earlier years and substantially lower cash flows in the latter years.

Because of their structure, interest rate changes have an opposite effect on principal-only and interest-only strips. Rising rates increases the discount rate applied to cash flows, reducing the price of principal only strips; but since rising rates reduce prepayment levels, making mortgages last longer, interest-only strips will rise in price. Likewise, when interest rates are falling, principal-only strips will rise, while interest-only strips will decline.

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