Interest Only (IO) Strips: Definition and How They Work

What Are Interest Only Strips?

Sometimes investment firms or dealers take a debt obligation or pool of obligations—mortgages, Treasury bonds, or other bonds—and after separating their principal and interest portions, sell them as distinct security products to investors, thus creating what's known as a strip bond. An interest only strip is one of these separated securities—the part that consists only of the interest portion of the monthly payments.

Although interest only strips can be created out of any debt-backed security that generates periodic payments, the term is usually associated with mortgage-backed securities (MBS).

Key Takeaways

  • Interest only (IO) strips are a financial product created by separating the interest and principal payments of a debt-backed security. The IO strip represents the interest stream.
  • While they can be created out of any loan, bond, or debt pools, IO strips are usually associated with mortgage-backed securities (MBS).
  • The investor in the interest only strip benefits when interest rates are rising: Borrowers tend not to prepay or refinance their mortgages in such environments, so the income stream from the IO strip stays steady.

How Interest Only Strips Work

The process of separating the principal and interest on a debt obligation is known as stripping. A mortgage-backed security (MBS) that goes through this process—separating the interest and principal payment streams—is referred to as stripped MBS.

The other half of the stripped security—the portion that is not the interest only strip—is known as a principal only (PO) strip. Investors who buy principal only strips receive the portion of the monthly payment from the underlying mortgage pool that is applied to the balance of the loan.

Since the underlying assets in an MBS are mortgages, the interest only strip functions like the interest payment portion of a mortgage. Interest is the greater portion of a mortgage payment in the early years of the mortgage. In later years, the interest-payment portion becomes smaller as more of the payment goes to the principal. At the same time, investors receive smaller payments from interest-only strips as they approach the end of the mortgage period.

Interest Rate Considerations

Interest only strips were created to appeal to investors with a particular view of the interest rate environment. All debt obligations are sensitive to changes in the interest rate environment but mortgages are particularly sensitive. When interest rates drop, borrowers have both the option (and an incentive) to refinance their mortgages at the current, lower interest rate. This leads to prepayment risk for investors who are holders of the interest only strips of a stripped MBS. If prepayment were to occur, investors would forfeit future interest payments and receive nothing from the return of the principal.

However, when the prepayment rate on the underlying debt is low and interest rates are rising, investors who are holders of interest only strips are in the position to benefit because, figuring they have the best deal available, this kind of interest rate environment encourages borrowers to hang onto their current mortgages.

With a complete MBS or a bond, the holder generally wants the payments to occur as planned over the life of the investment. However, a stripped product introduces different desires regarding the performance of the underlying debt depending on the portion of the security that the investor holds.

While the interest only strip holders want to see rising rates and no prepayment, principal only strip holders welcome prepayment actions and the lowering interest rates that prompt borrowers to refinance. In practice, investors generally don’t make a binary play on interest or principal only strips, but construct holdings that have a bias toward one or the other without leaving the downside entirely unhedged.

Special Considerations

The Role of Stripped Payments in Financial Valuation

Financial engineers, such as Wall Street dealers, frequently strip and restructure bond payments in an effort to earn arbitrage profits. For example, the periodic payments of several bonds can be stripped to form synthetic zero-coupon bonds. Zero-coupon Treasury strips are an important building block in many financial calculations and bond valuations. The zero-coupon or spot-rate Treasury yield curve is used in option-adjusted spread (OAS) calculations and for other valuations of bonds with embedded options.

Moreover, an interest strip can be reintegrated into other synthetic products. For example, interest only strips can be pooled to create or make up a portion of a larger collateralized mortgage obligation (CMO), asset-backed security (ABS) or collateralized debt obligation (CDO) structure.