What Are Principal Only Strips (PO Strips)?
Principal only strips (PO strips) are a fixed-income security where the holder receives the non-interest portion of the monthly payments on the underlying loan pool. Principal only strips are created when loans are pooled into securities and then split into two types. One type is the interest only (IO) strip that feeds investors the interest from each underlying payment. The other type is the principal only strip where the investor gets the portion of the payment meant for actual payment on the balance of the loan.
Although principal only strips can be created out of any debt-backed security, the term is most strongly associated with mortgage-backed securities (MBS). The mortgage-backed securities that are split into PO and IO strips are referred to as a stripped MBS. Investors in PO strips benefit from faster repayment speeds while also being protected from contraction risk. This means that, unlike a usual bond or traditional MBS, the PO investor will benefit from decreases in the interest rate as the loans are likely to get repaid faster.
- A principal only (PO) strip is the part of a stripped MBS where the holder only receives principal payments. The other part of a stripped MBS is an interest only (IO) strip.
- PO strips holders prefer to have their principal paid back quickly, like when the mortgage borrowers make additional payments, refinance, or interest rates drop (which tends to increase refinancing).
- An IO strip holder prefers if interest rates hold steady or rise, and that mortgage borrowers don't make additional payments since this will cut down on the interest the holder receives.
Understanding Principal Only Strips (PO Strips)
Principal only strips were created to appeal to a particular investor based on his or her view of the interest rate environment. Mortgages are sensitive to changes in the interest rate because borrowers have the option to refinance if the current rate is below the rate they are paying on their mortgage. When a borrower can save money by refinancing to a lower rate, the mortgage in the MBS is paid off as part of the refinancing.
This prepayment risk is important to consider when evaluating a traditional MBS, as the holder wants to get as many payments and as much interest as possible out of each loan. A stripped MBS, however, is not a traditional MBS. A stripped MBS allows investors to make different bets within the same mortgage pool. The IO investor will want lots of interest payments which means they prefer if mortgage borrowers don't pay their loans off early. The PO investor is only getting the principle, so they want that loan paid off as quickly as possible.
Principal Only (PO) Strips versus Interest Only (IO) Strips
When interest rates are low and prepayment within an MBS is high, principal only strips enjoy a greater yield. The investors holding PO strips will only ever see the face value of their investment, so they benefit when the time spent in the investment is shortened. PO strips are sold at a discount to face value, so there is a yield built in. The yield increases if the principal is received in a shorter amount of time. For example, if you make 3% per year on a loan but the person pays you the 3% in only six months, your yield has essentially doubled because you made your money in half the time expected.
Interest only strip holders want to see the opposite situation occur. They want to see interest rates at the same level or higher so that the mortgage holders in the pool keep making payments (including interest) on their current loan rather than trying to refinance into a new one.
In practice, the IO and PO strip holders are not necessarily at odds, and many investors may hold some mix of both. A stripped MBS can be customized so that an investor can get exposure to rising interest rates through IO strips, for example, while also keeping some of the investment in the PO strips to hedge against an unexpected reversal.
Example of a Principle Only (PO) Strip
A mortgage backed security will typically contain many mortgages packaged together. The MBS is then bought and sold between parties, or it can be stripped into a PO and IO, then those individual securities can be bought and sold.
Assume for a moment that an MBS has only one $1 mortgage. The same concept applies if it was 1,000 x $100,000 mortgages, 10,000 x $10,000 loans, or hundreds of million dollar mortgages. The only difference is that with more loans, if a few people default it doesn't have a large impact on the whole security. If there are only a few mortgages in the pool, even one default could have a big impact on the performance of the MBS.
If the MBS has been separated into IO and PO components, when the loan borrowers pay interest on the loan the IO holders receive the cash inflow, and when the loan borrowers pay principle the PO holder receives the cash inflow from that.
A mortgage or loan payment is a combination of both principal and interest. Assume that on the $1 million mortgage the payment is $6,500 per month. In the first several years the mortgage is paid, more than half of the payment is likely to be interest and the other portion principle. As time goes on, more principal is paid with each payment and less interest. Therefore, IO holders tend to get bigger cash inflows in the earlier years of the mortgage and smaller inflows in later years. The PO holder gets smaller cash inflows in the early years but they get progressively larger as time passes.
If interest rates rise or stay steady, the mortgage borrower is less likely to refinance and more likely to keep paying their current mortgage rate. This favors the IO holders.
If interest rates fall, the mortgage borrower has more incentive to refinance the mortgage at a lower rate. When this happens, the original loan is paid off by the bank and a new loan is issued. This favors the PO holder since it greatly increases the speed at which they receive their capital/principal.