What is a PO security? What is an IO security?

Question

What will be an ideal response?

Answer 1

In early 1987, stripped MBS began to be issued where all the interest is allocated to one class (the IO class) and the entire principal to the other class (the PO class). The IO class receives no principal payments. IOs and POs are referred to as mortgage strips. Additional details for POs and IOs are discussed below.

The PO security is purchased at a substantial discount from par value. The yield an investor will realize depends on the speed at which prepayments are made. The faster the prepayments, the higher the yield the investor will realize. For example, suppose that there is a pass-through backed by 30-year mortgages with $400 million in par value and that investors can purchase POs backed by this pass-through for $175 million. The dollar return on this investment will be $225 million. How quickly that dollar return is recovered by PO investors determines the yield that will be realized. In the extreme case, if all the homeowners in the underlying mortgage pool decide to prepay their mortgage loans immediately, PO investors will realize the $225 million immediately. At the other extreme, if all homeowners decide to keep their houses for 30 years and make no prepayments, the $225 million will be spread out over 30 years, which will result in a lower yield for PO investors.

The price of the PO can be expected to change as mortgage rates in the market change. When mortgage rates decline below the coupon rate, prepayments are expected to speed up, accelerating payments to the PO holder. Thus the cash flow of a PO improves (in the sense that principal repayments are received earlier). The cash flow will be discounted at a lower interest rate because the mortgage rate in the market has declined. The result is that the price of a PO will increase when mortgage rates decline. When mortgage rates rise above the coupon rate, prepayments are expected to slow down. The cash flow deteriorates (in the sense of its taking longer to recover principal repayments). Coupled with a higher discount rate, the price of a PO will fall when mortgage rates rise.

When an IO is purchased there is 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.