What are Principal Only Strips - PO
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, and 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 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 investor will benefit from decreases in the interest rate.
BREAKING DOWN Principal Only Strips - PO
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 bets aren't on the particular mortgages, but on the direction of interest rates in the near future.
Principal Only Strips versus Interest Only 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 actually sold at a discount to face value, so there is a yield built in but it goes up the faster that face value can be recovered. Interest only strip holders, of course, want to see the exact opposite situation. 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.