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.