Why would premium PACs and interest-only strips offer higher yields if the market expects that prepayments will accelerate or are highly uncertain?

Question

What will be an ideal response?

Answer 1

Prepayments will be expected to accelerate if interest rates are expected to decline or if there is
a greater possibility of decline due to general uncertainty as to which way rates will change. For such a situation, investors would expect to deal with greater reinvestment rate risk. To compensate for this risk, investors would have to be given higher rates of return for investing in securities that will be retired earlier than desired. More details on how this affects both planned amortization tranches (PAC tranches) and interest-only strips (I-Os or just IOs) are given below.

PAC tranches can reduce prepayment risk in a manner desired by an investor's preference. However, despite the redistribution of prepayment risk with sequential-pay and accrual collateralized mortgage obligations (CMOs), there is still considerable prepayment risk. That is, there is still considerable average life variability for a given tranche. This problem is mitigated by the PAC tranche. The greater predictability of the cash flow for PAC bonds occurs because there is a principal repayment schedule that must be satisfied. PAC bondholders have priority over all other classes in the CMO issue in receiving principal payments from the underlying collateral. The greater certainty of the cash flow for the PAC bonds comes at the expense of the non-PAC classes, called support or companion bonds. It is these bonds that absorb the prepayment risk. Because PAC bonds have protection against both extension risk and contraction risk, they are said to provide two-sided prepayment protection.

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. 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. 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.