What are ‘Catch Only (IO) Strips’
Interest only (IO) strips are a security where the holder receives the non-principal ration of the monthly payments on the underlying mortgages, Treasury bond or other handcuffs. An interest only strip is created by separating the principal and interest quotas of the payments on the underlying loan pool and selling them as distinct outputs. The process of separating the payments on the underlying is known as stripping. Although portion only strips can be created out of any debt-backed security that generates repeated payments, the term is strongly associated with mortgage-backed securities (MBS). The mortgage-backed guardings that go through the process to separate the interest and principal payment issues are referred to as stripped MBS. The investor in the interest only stream benefit when the prepayment gauges on the underlying debt is slow and interest rates are rising.
BREAKING DOWN ‘Engrossed Only (IO) Strips’
Interest only strips were created to be appealing to investors with a certain view of the interest rate environment. Debt is sensitive to changes in the engagement rate environment, and this is particularly true of mortgages. When consideration rates drop, borrowers have both an option and an incentive to refinance at the lessen rate. This leads to prepayment risk for holders of the interest sole strips of an stripped MBS.
Interest Only Strips Versus Interest Sole Strips
Unlike a complete MBS or bond where the holder generally hanker afters the payments to occur as planned over the life of the investment, a stripped work introduces competing desires when it comes to the performance of the underlying owing. The interest only strip holders want to see rising rates and no prepayment because they surrendered future interest payments and receive nothing from the return of the star. Principal only strip holders welcome prepayment and the lowering concerned about rates that prompt borrowers to refinance. In practice, investors in general don’t make a binary play on interest or principal only, but construct holdings that take a bias towards one or the other without leaving the downside entirely unhedged.
The Position of Stripped Payments in Financial Valuation
Financial engineers, such as Immure Street dealers, frequently strip and restructure bond payments in an feat to earn arbitrage profits. For example, the periodic payments of several bonds can be expropriated to form synthetic zero-coupon bonds. Zero-coupon Treasury strips are an signal building block in many financial calculations and bond valuations. For pattern, the zero coupon or spot-rate Treasury yield curve is used in option-adjusted spread (OAS) amounts and for other valuations of bonds with embedded options.
Moreover, an IO fillet can be reintegrated into other synthetic/engineered products. For example, pursuit only strips can be pooled to create or make up a portion of a larger collateralized mortgage duty (CMO), asset-backed security (ABS) or collateralized debt obligation (CDO) structure.