Question

The process of separating the principal and interest on a debt obligation is known as stripping. A mortgage-backed security (MBS) that goes through this process—separating the interest and principal payment streams—is referred to as stripped MBS. Since the underlying assets in an MBS are mortgages, the interest only(IO) strip functions like the interest payment portion of a mortgage. The other half of the stripped security—the portion that is not the interest only strip—is known as a principal only (PO) strip. Investors who buy principal only strips receive the portion of the monthly payment from the underlying mortgage pool that is applied to the balance of the loan. Given the prepayment pattern of the Agency fixed-rate MBS follows the S-Curve pattern, i.e., sensitive to market interest rates, the future cashflows and valuation of an IO strip depend on the interest rate levels. The higher market mortgage rates, the slower projected prepayment speeds, and longer interest cashflows and higher valuation. Vice versa. For such cashflow and valuation pattern, what is the sign of the duration of an IO strip? Why?

Answer 1

The duration of an IO strip is typically negative because higher market interest rates lead to slower prepayment speeds and longer cash flow timelines, while lower rates result in faster prepayment speeds and shorter timelines.

Step-by-step explanation:

The duration of an interest only (IO) strip is typically negative. This is because as market interest rates rise, prepayment speeds on mortgages slow down, meaning that the expected cash flows from the IO strip are pushed further into the future, diminishing current valuation. The opposite is true for falling interest rates; prepayment speeds tend to increase, leading to shorter cash flows and reduced valuation of the IO strip.

Let's visualize this concept with an example. Imagine an IO strip with a stream of interest payments from a pool of mortgages. If interest rates increase, homeowners are less likely to refinance their mortgages, which leads to slower prepayments. For an IO strip investor, this means that they will receive interest payments for a longer period than originally anticipated, and the present value of those prolonged payments is lower because they are discounted over a longer period. Conversely, if interest rates decrease, homeowners are more likely to refinance, leading to faster prepayments and a shorter lifespan for the IO strip payments, resulting in a higher present value because the payments are discounted over a shorter period.