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

RELATED TERMS
  1. Principal Only Strips - PO

    Principal only strips are the portion of a stripped MBS that ...
  2. Strip

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

    A futures strip is the sale or purchase of futures contracts ...
  4. Servicing Strip

    A servicing strip is a type of security created by the stream ...
  5. Treasury STRIPS

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

    A strip bond is a bond where both the principal and regular coupon ...
Related Articles
  1. Trading

    Strip Options: A Market Neutral Bearish Strategy

    Strip Options are market neutral trading strategies with profit potential on either side price movement, with a "bearish" skew.
  2. Investing

    Who Should Get an Interest-Only Mortgage?

    In the right circumstances, interest-only loans can save you money and help accomplish financial goals; in the wrong circumstances they can be very costly.
  3. Investing

    The Risks Of Mortgage-Backed Securities

    Find out how weighted average life guards against prepayment risk.
  4. 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.
  5. Insights

    The Mortgage-Backed Security Market Faces Major Tumoil

    The Fed is expected to begin selling off its $1.75 trillion portfolio of mortgage-backed securities.
  6. Investing

    Top 3 Mortgage Backed Securities (MBS) ETFs (MBB, MBG)

    Discover some of the best opportunities for investors seeking exposure to mortgage-backed securities through utilizing exchange-traded funds.
  7. Investing

    3 Best High-Yielding Long Term Government Bond ETFs (EDV, ZROZ)

    Learn about three exchange-traded funds that invest in long-term U.S. government bonds and offer high distribution yields to investors.
  8. Personal Finance

    Interest-Only Mortgages: Home Free or Homeless?

    These loans can be beneficial, but for many borrowers, they present a financial trap.
  9. Personal Finance

    ARMed And Dangerous

    In a climate of rising interest rates, having an adjustable-rate mortgage can be risky.
RELATED FAQS
  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. What is securitization?

    Securitization involves taking an illiquid asset, or group of assets, and transforming it into a security. A typical example: ... Read Answer >>
  3. Are all mortgage backed securities (MBS) also collateralized debt obligations (CDO)?

    Learn more about mortgage-backed securities, collateralized debt obligations and synthetic investments. Find out how these ... Read Answer >>
  4. The Differences Between a Collateralized Debt Obligation (CDO) and an Asset Backed ...

    Learn about the differences in relationships between asset-backed securities (ABS) and collateralized debt obligations (CDOs) Read Answer >>
Hot Definitions
  1. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  2. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  3. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  4. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
  5. Dividend

    A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
  6. Inventory Turnover

    Inventory turnover is a ratio showing how many times a company has sold and replaces inventory over a period.
Trading Center