How are interest-only (IO) strips priced and why do they behave inversely to most bonds when rates fall?

Interest-only (IO) strips receive only the interest component of mortgage payments, with no principal. Their pricing is dominated by prepayment risk, which creates behavior opposite to conventional bonds.

Why IOs Behave Inversely:

IO value = Sum of PV(interest payments on outstanding principal)

When rates fall:

1. Homeowners refinance → prepayments accelerate
2. Outstanding principal declines faster
3. The notional amount generating interest shrinks
4. Future interest payments are smaller and fewer
5. IO value decreases despite the lower discount rate

The prepayment effect dominates the discount rate effect, creating negative duration — a unique characteristic among fixed income instruments.

Numerical Example:

Consider an IO strip on a $100M mortgage pool at 6% WAC.

Scenario 1 — Low Prepayments (100 PSA):

Scenario 2 — High Prepayments (400 PSA):

The IO strip loses $19.5M in value (51% decline) when prepayments accelerate — a massive negative convexity.

Pricing Implications:

• Negative duration: IO prices move in the same direction as interest rates (rates down → IO down)
• Negative convexity: The IO's price-rate relationship is concave, not convex
• Volatility sensitivity: Higher rate volatility hurts IO valuations because it increases the probability of prepayment scenarios

Who Uses IO Strips?

1. Hedgers: Mortgage servicers whose servicing income (which is IO-like) needs to be hedged
2. Macro traders: Taking a view that rates will rise (IO profits from rising rates)
3. Portfolio diversifiers: IOs' negative duration offsets the positive duration of a traditional bond portfolio

CFA Exam Focus: Know that IO strips have negative duration, understand the prepayment mechanism, and be able to explain why they gain value when rates rise.

For more MBS derivatives, check our CFA fixed income course.