Why do IO strips have inverse price behavior to most bonds?

Question

AcadiFi · Accepted Answer

An Interest-Only (IO) strip is the receive-interest leg of a stripped MBS: the holder gets all the interest cash flow, zero principal. Its value is therefore entirely determined by how long the underlying principal stays outstanding.

Pricing intuition: if a $100M pool pays 5% interest per year on its remaining balance, the IO earns 5% × (average balance). Anything that shrinks the balance faster — fast prepayments — destroys the IO's revenue stream. Anything that slows prepayments — rates rising — is gold.

Mechanics through a rate move:

- Rates fall → refi wave → pool balance plummets → IO cash flow vanishes → IO price crashes.
- Rates rise → refi stalls → pool balance persists → IO coupons keep flowing → IO price rises.

Thus an IO has negative effective duration in the typical rate range: duration ≈ −10 is common for current coupon IOs. This is why dealers use IOs as convexity hedges against other MBS holdings that suffer in rising rates.

Risk: IOs have no principal protection. If a pool is paid off entirely, the IO is worth zero. They are also extremely sensitive to OAS spread widening. The classic 1994 and 2003 IO blow-ups came from simultaneous spread widening and prepayment shocks.

Trade sizing rules of thumb: size IO exposure by 'option-adjusted duration contribution', not notional.

Why do IO strips have inverse price behavior to most bonds?

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