What Is a 'Stripped MBS'

A stripped MBS, or stripped mortgage-backed security (MBS), is a type of mortgage-backed security that is split into principal-only strips and interest-only strips. Stripped MBS derive their cash flows either from principal payments or interest payments on the underlying mortgages, unlike conventional MBS where cash flows are based on both principal and interest payments. Stripped MBS are very sensitive to interest rate changes.

Breaking Down 'Stripped MBS'

Stripped MBS were created to appeal to different types of investors. There are some fundamental differences between principal-only strips and interest-only strips. Principal-only strips consist of a known dollar amount, but the payment timing is unknown. They are sold to investors at a discount on face value, which is based on interest rates and prepayment speed. Interest-only strips generate high levels of cash flow in the earlier years and substantially lower cash flows in the latter years. Investors can choose between the principal-only strips and the interest-only strips based on what they think interest rates will do in the future. 

Stripped Mortgage-Backed Securities and Interest Rate Risk

Because of their structure, interest rate changes have an opposite effect on principal-only and interest-only strips. Rising rates increases the discount rate applied to cash flows, reducing the price of principal-only strips. The yield on principal-only strips is affected directly by the prepayment speed; the faster the prepayment on the principal, the higher the overall yield for the principal-only strip investor. Since prepayment increases as interest rates fall, principal-only investors want lower interest rates. On the opposite side, interest-only strips rise in price along with rising interest rates. Higher interest rates also reduce prepayment levels, so the mortgages last longer and the interest-only strips will rise in price because they will be collecting interest longer.

Simply put, when interest rates are falling, principal-only strips will rise in price and interest-only strips will decline. Conversely, when interest rates are rising, interest-only strips rise in price and principal-only strips will decline. If an investor believes interest rates are on the rise, then he or she will buy the interest-only strips. If, instead, an investor believes interest rates will decline, he or she buys the principal-only strips. This is where the marketing aspect of the stripped MBS comes in. Unlike a traditional MBS that carries both principal and interest, the stripped MBS allows an investor to make an investment based on his or her market outlook. Moreover, stripped MBS can be tailored for investors so that they are comprised of more interest or more principal, offering the investor a customized amount of interest rate risk

  1. Interest Only (IO) Strips

    Interest only (IO) strips are a financial product created by ...
  2. Servicing Strip

    A servicing strip is a type of security created by the stream ...
  3. Strip

    The strip is the process of removing coupons from a bond and ...
  4. Futures Strip

    A futures strip is the sale or purchase of futures contracts ...
  5. Treasury STRIPS

    Treasury STRIPS are an acronym for 'separate trading of registered ...
  6. Loan Strip

    A loan strip is a type of commercial loan sale whereby funding ...
Related Articles
  1. Personal Finance

    How Interest-Only Mortgages Work

    Sophisticated borrowers may consider one of these interest-only loans to keep their initial mortgage payments low, but should understand the risks first.
  2. Retirement

    Interest-only retirement: Can it be done?

    Spending investment interest in retirement can be a viable strategy, but it won't work for everyone.
  3. Investing

    The Risks of Mortgage-Backed Securities

    Find out how weighted average life for mortgage-backed securities (MBS) guards against prepayment risk. Determine how yields are affected by the market.
  4. Investing

    Top Mortgage-Backed Securities ETFs

    Investing in mortgage-backed securities has many advantages, but studying their history may make you wary.
  5. Investing

    Asset-backed and mortgage-backed securities: An introduction

    Learn more about the structure of asset-and mortgage-backed securities, securities backed by pools of mortgage or non-mortgage assets, along with some examples of ABS, MBS and their valuations. ...
  6. Investing

    MBB: iShares Barclays MBS Bond Fund ETF Analysis

    Explore the iShares MBS ETF and see how this fund composed of agency-issued mortgage debt compares to similar ETFs in the category.
  7. Investing

    Do Retail Store Closings Create a Domino Effect?

    If brick-and-mortar retailers continue to close at today’s pace, here’s how it could play out.
  8. Investing

    Asset Allocation In A Bond Portfolio

    An investor's fixed-income portfolio can easily beat the average bond fund. Learn how and why!
  1. What is a stripped bond?

    A stripped bond is a bond that has had its main components broken up into a zero-coupon bond and a series of coupons. Read Answer >>
  2. How are gross profit and EBITDA different?

    Gross profit and EBITDA show the profitability of a company in different ways. Investors should know what goes into each ... Read Answer >>
Trading Center