What Are Interest Only Strips?
Sometimes investment firms or dealers take a debt obligation or pool of obligations—mortgages, Treasury bonds or other bonds—separate their principal and interest portions, and sell them as distinct security products to investors, creating what's known as a strip bond. An interest only strip is one of these separated securities—the part that 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 strongly associated with mortgage-backed securities (MBS).
- 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.
Interest Only Strips Explained
The process of separating principal and interest on a debt obligation is known as stripping. The mortgage-backed securities (MBS) that go through the process that separates the interest and principal payment streams are referred to as stripped MBS.
The other half of the stripped bond or stripped MBS—the inverse of the IO strip—is known as a principal only (PO) strip. Investors who buy these receive the portion of the monthly payment from the underlying mortgage pool that is applied to the balance of the loan.
Interest only strips were created to be appealing to investors with a particular view of the interest rate environment. Debt obligations are sensitive to changes in the interest rate environment—particularly mortgages. When interest rates drop, borrowers have both an option and an incentive to refinance their mortgages at the lower rate. This leads to prepayment risk for holders of the interest only strips of a stripped MBS. The investor in the interest only strip benefits when the prepayment rate on the underlying debt is low and interest rates are rising—because that encourages borrowers to hang onto their current mortgages, figuring they have the best deal.
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 IO strip can be reintegrated into other synthetic/engineered 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.
Unlike a complete MBS or bond where the holder generally wants the payments to occur as planned over the life of the investment, a stripped product introduces competing desires when it comes to the performance of the underlying debt. The interest only strip holders want to see rising rates and no prepayment because they forfeit future interest payments and receive nothing from the return of the principal. Principal only strip holders welcome prepayment 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, but construct holdings that have a bias toward one or the other without leaving the downside entirely unhedged.