What is the synthetic coupon rate on Class X-2?
What will be an ideal response?
Class X-2 receives 25% of the principal and 90% or 0.9 of the interest. Because the coupon rate is 8%, it effectively will receive 0.9(8%) = 7.2%. More details are supplied below concerning the relationship between yield and price that Class X-2 investors can expect.
A stripped MBS is created by altering the distribution of principal and interest from a pro rata distribution to an unequal distribution. Some of the securities thus created will have a price-yield relationship that is different from the price-yield relationship of the underlying mortgage pool. Class X-2 receives 25% of the principal and 90% of the interest. Thus, it is more like an IO, which when purchased has no par value. In contrast to the PO investor, the IO investor wants prepayments to be slow. The reason is that the IO investor receives only interest on the amount of the principal outstanding. As prepayments are made, the outstanding principal declines, and less dollar interest is received. In fact, if prepayments are too fast, the IO investor may not recover the amount paid for the IO thus realizing a low effective yield.
Exhibit 12-19 shows for various mortgage rates the price of (i) a 9% pass-through, (ii) a PO created from this pass-through, and (iii) an IO created from this pass-through. Notice that as mortgage rates decline below 9%, the price of the pass-through does not respond much. This is the negative convexity (or price compression) property of pass-throughs. For the PO security, the price falls monotonically as mortgage rates rise. For the IO security, at mortgage rates above approximately 11%, the price declines as mortgage rates rise; as mortgage rates fall below about 11%, the price of an IO falls as mortgage rates decline. Both POs and IOs display substantial price volatility when mortgage rates change. The greater price volatility of the IO and PO compared with the pass-through from which they were created can be seen by the steepness of a tangent line to the curves at any given mortgage rate.
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