What Is a Stripped MBS?
A stripped mortgage-backed security (MBS) is a type of mortgage-backed security that is split into principal-only and interest-only strips. They derive their cash flows either from principal or interest payments on the underlying mortgages, unlike conventional MBSs that generate income from both of these two sources.
- A stripped mortgage-backed security (MBS) is a type of mortgage-backed security that is split into principal-only and interest-only strips.
- Income is derived either from principal or interest payments on the underlying mortgages, unlike conventional MBSs whose cash flows are based on both.
- The profitability of principal-only strips and interest-only strips mainly hinge on the direction of interest rates.
Understanding Stripped MBS
Mortgage-backed securities (MBSs) are investments made up of a bundle of home loans bought from the banks that issued them. Investing in an MBS means purchasing the rights to these various mortgages. If all goes to plan and the homebuyers don't default, they should pay out regular monthly interest payments, the amount the lender charges to borrow the money, as well as the actual repayment of the loan, otherwise known as the principal.
Stripped MBSs were created to appeal to different types of investors, giving them the option to get their hands on either the interest or the principal payments, rather than both. The investor is free to decide which strategy to pursue, based on his or her income needs and the market outlook. Specifically, this requires predicting where interest rates are heading.
Principal-Only Strips vs. Interest-Only Strips
There are some fundamental differences between principal-only strips and interest-only strips.
Principal-only strips consist of a known dollar amount but an unknown payment timing. They are sold to investors at a discount on face value, which is determined by interest rates and prepayment speed.
Interest-only strips, on the other hand, 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.
Because of their structure, interest rate changes have an opposite effect on principal-only and interest-only strips. Rising rates increase 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 yearn for lower interest rates.
In contrast, interest-only strips rise in price when interest rates are pushed up. Higher interest rates also reduce prepayment levels, leading the mortgages to last longer. Under these circumstances, the interest-only strips will climb in value because they will be collecting interest over a lengthier period of time.
A stripped MBS can be tailored to consist of more interest or more principal, offering the investor a customized amount of interest rate risk.
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 climb in price and principal-only strips will decline. In other words, if an investor believes interest rates are on the rise, he or she will buy the interest-only strips. If, instead, an investor believes interest rates will decline, he or she will buy the principal-only strips.