What are Interest Only (IO) Strips
Interest only (IO) strips are a security where the holder receives the non-principal portion of the monthly payments on the underlying mortgages, Treasury bonds or other bonds. An interest only strip is created by separating the principal and interest portions of the payments on the underlying loan pool and selling them as distinct products. The process of separating the payments on the underlying debts is known as stripping. 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). The mortgage-backed securities that go through the process that separates the interest and principal payment streams are referred to as stripped MBS. The investor in the interest only stream benefits when the prepayment rate on the underlying debt is low and interest rates are rising.
BREAKING DOWN Interest Only (IO) Strips
Interest only strips were created to be appealing to investors with a particular view of the interest rate environment. Debt is sensitive to changes in the interest rate environment, and this is particularly true of mortgages. When interest rates drop, borrowers have both an option and an incentive to refinance at the lower rate. This leads to prepayment risk for holders of the interest only strips of a stripped MBS.
Interest Only Strips versus Principal Only Strips
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.
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. For example, 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.