How is the price of an interest-only security expected to change when interest rates change?

Question

What will be an ideal response?

Answer 1

The price of an interest-only security (IO) can move in various directions depending on the direction of the change in interest rates and also the change relative to the coupon rate. Details on the precise expectations of IO price changes are supplied below.

If mortgage rates decline below the coupon rate, prepayments on the interest-only security (IO) are expected to accelerate. This results in a deterioration of the expected cash flow for an IO. Although the cash flow will be discounted at a lower rate (causing an increase in the IO price), the net effect is typically a decline in the price of an IO. If mortgage rates rise above the coupon rate, the expected cash flow improves but the cash flow is discounted at a higher interest rate (causing a decrease in the IO price). The net effect may be either a rise or a fall for the IO. Thus we see an interesting characteristic of an IO: Its price tends to move in the same direction as the change in mortgage rates. This effect occurs (i) when mortgage rates fall below the coupon rate, and (ii) for some range of mortgage rates above the coupon rate.

An example of this effect can be seen in Exhibit 12-19, which 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.