How do IO and PO strips work and why do they have opposite sensitivities to interest rates?

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AcadiFi · Accepted Answer

IO and PO strips are created by splitting a mortgage-backed security's cash flows into their two components. Their opposite rate sensitivities make them powerful hedging tools — and a popular CFA exam topic. **The Basic Split** A mortgage payment has two parts: interest (on remaining balance) and principal (amortization + prepayments). A PO strip receives only the principal payments. An IO strip receives only the interest payments. **Why Prepayment Speed Is Everything** Mortgage borrowers can prepay their loans early (usually by refinancing when rates drop). This prepayment behavior drives the opposite sensitivities: ```mermaid graph TD A["Interest Rates Fall"] --> B["Prepayments Accelerate
Homeowners refinance"] B --> C["PO Strip BENEFITS
Get par value back faster
at a discount = profit"] B --> D["IO Strip SUFFERS
Interest stream ends early
smaller remaining balance"] E["Interest Rates Rise"] --> F["Prepayments Slow Down
Homeowners keep existing mortgage"] F --> G["PO Strip SUFFERS
Par repaid slowly
discounted longer"] F --> H["IO Strip BENEFITS
Interest earned longer
on larger balance"] style C fill:#2d6a4f,color:#fff style D fill:#8b0000,color:#fff style G fill:#8b0000,color:#fff style H fill:#2d6a4f,color:#fff ``` **PO Strip Mechanics — Bayfield Mortgage Trust** Bayfield creates a PO strip from a pool of $100M in mortgages with a 5.5% weighted average coupon. The PO strip is priced at $85M (a discount to par) because principal comes back slowly over 30 years. Rates drop to 3.5%: Homeowners refinance aggressively. Instead of receiving $100M over 30 years, the PO holder gets $100M back in just 5-7 years. Receiving par ($100M) back faster when you paid $85M is extremely profitable — the annualized return spikes. Rates rise to 7.5%: Nobody refinances. Principal trickles in over the full 30 years. The PO holder waits decades for par, and the present value of that slow stream at the higher discount rate drops well below $85M. **IO Strip Mechanics** The IO strip receives only interest payments, calculated on the outstanding balance. As borrowers prepay, the balance shrinks, and so does the interest income. Rates drop: Massive prepayments wipe out the balance quickly. The IO holder's interest stream vanishes. Even though lower rates normally boost bond prices, the IO strip's value falls — this is **negative duration** behavior. Rates rise: Minimal prepayments. The balance stays large, and interest keeps flowing for decades. The IO strip's value rises. **Negative Duration of IO Strips:** Most bonds have positive duration (price rises when rates fall). IO strips have negative duration because: - Rates fall → prepayments surge → IO cash flows shrink drastically → IO price falls - The prepayment effect overwhelms the normal discounting effect **Practical Uses:** - PO strips: Bet on falling rates, hedge against rate declines - IO strips: Bet on rising rates, hedge against rate increases (rare property for fixed income) - IO strips can hedge the negative convexity of callable bonds or MSRs (mortgage servicing rights) **Exam Tip:** CFA Level II loves scenario questions: 'If prepayment speeds double, which strip benefits?' PO always benefits from faster prepayments; IO always suffers. Explore MBS analytics in our CFA Level II Fixed Income resources.

How do IO and PO strips work and why do they have opposite sensitivities to interest rates?

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