How does a PO strip behave and why is it called a leveraged rate play?

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AcadiFi · Accepted Answer

A Principal-Only (PO) strip is the complement to the IO: the holder receives all principal cash flow (scheduled amortization plus prepayments), no interest. POs are deep-discount instruments — you buy at a steep discount to face and get paid back at par through principal remittances.

Price driver: the faster principal comes back, the higher the yield. So POs love prepayments.

- Rates fall → refi wave → principal returned early at par → PO yield rockets → price jumps sharply.
- Rates rise → prepayments slow → par payoff delayed → PO yield drops → price falls harder than a regular bond.

POs thus have positive and very large duration (often 15-25) and positive convexity. A current-coupon PO can move 8-12 points on a 50 bp rate move — hence the 'leveraged rate play' label.

```mermaid
flowchart LR
  Pool[Pool cash flow] --> IO[IO: all interest]
  Pool --> PO[PO: all principal]
  RatesDown[Rates fall] -->|slow collapse| IO
  RatesDown -->|fast payoff| PO
```

POs are popular as a synthetic long-duration hedge: pairing a PO with an IO roughly reconstructs the original MBS but each leg is separately tradable. Risk managers monitor the 'PO/IO combo trade' because pair correlations can break down in stress scenarios — 1994 and 2013 both saw simultaneous losses on both legs.

How does a PO strip behave and why is it called a leveraged rate play?

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