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Stripped Mortgage-Backed Securities (MBS): Meaning, How They Work, Risks, and Benefits

Last updated 03/29/2024 by

Dan Agbo

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Stripped MBS, or stripped mortgage-backed securities, are investments that separate the principal and interest portions of mortgage-backed securities into individual securities. This article explains the concept of stripped MBS, how it works, the differences between principal-only strips and interest-only strips, and the impact of interest rate changes on these investments.

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Understanding stripped MBS

Stripped MBS, also known as stripped mortgage-backed securities, are a specialized type of investment instrument designed to divide the cash flows from underlying mortgage-backed securities into distinct components known as principal-only strips and interest-only strips. Unlike traditional MBSs that generate income from both principal repayments and interest payments on the underlying mortgages, stripped MBSs isolate either the principal or interest payments, providing investors with tailored investment options based on their risk preferences and market outlook.
Investors in stripped MBSs essentially receive cash flows from either the repayment of the loan principal or the interest payments made by borrowers. This segmentation allows investors to customize their exposure to different types of risks associated with mortgage-backed securities, such as interest rate fluctuations and prepayment speeds.

Principal-only strips vs. Interest-only strips

Principal-only strips (PO strips) and interest-only strips (IO strips) are integral components of stripped MBSs, offering distinct features and investment opportunities:

Principal-only strips

Principal-only strips represent a fixed dollar amount of the underlying mortgage-backed security’s principal. However, the timing of these payments is uncertain, as they are dependent on the prepayment speeds of the underlying mortgages. Investors can purchase PO strips at a discount to their face value, influenced by prevailing interest rates and anticipated prepayment rates. During periods of low-interest rates and accelerated prepayments, PO strips can offer higher yields to investors.

Interest-only strips

Interest-only strips consist of the interest payments generated by the underlying mortgages. These strips typically yield higher cash flows initially, gradually declining over time as the underlying loans are repaid. Investors opt for IO strips based on their expectations of interest rate movements. During periods of rising interest rates, IO strips can appreciate in value as the extended duration of the underlying mortgages leads to increased interest income.

Special considerations

Stripped MBSs exhibit a high sensitivity to changes in interest rates, which can affect the performance of principal-only and interest-only strips differently:

Interest rates impact

Principal-only strips: Rising interest rates generally lead to a decrease in the prices of principal-only strips. This is because higher rates result in slower prepayment speeds, reducing the cash flows received by PO strip investors. Conversely, falling interest rates can boost PO strip prices due to accelerated prepayments.
Interest-only strips: Higher interest rates tend to increase the value of interest-only strips. This is because extended mortgage durations result in prolonged interest payments, enhancing the cash flows for IO strip holders. Conversely, declining interest rates may diminish the value of IO strips as prepayment speeds accelerate, shortening the duration of interest payments.

Risks of stripped MBS

Investing in stripped MBSs entails certain risks that investors should carefully consider:

Interest rate risk

One of the primary risks associated with stripped MBSs is interest rate risk. These securities are highly sensitive to changes in interest rates, which can impact the value of principal-only and interest-only strips in opposite directions. If interest rates rise, the value of principal-only strips may decline due to slower prepayment speeds, while interest-only strips may appreciate due to extended durations of interest payments. Conversely, falling interest rates can lead to higher prepayment speeds, affecting the cash flows received by investors in both types of strips.

Prepayment risk

Stripped MBS investors also face prepayment risk, which refers to the risk that borrowers will repay their mortgages earlier than expected. Faster prepayments can impact the cash flows received by investors, particularly those holding principal-only strips. During periods of low-interest rates, borrowers may refinance their mortgages, leading to accelerated prepayment speeds and potentially reducing the yields for PO strip holders.

Market and credit risk

Additionally, stripped MBS investments are subject to market risk, including fluctuations in overall market conditions and investor sentiment. Economic factors, housing market trends, and regulatory changes can all influence the performance of stripped MBSs. Moreover, there is inherent credit risk associated with the underlying mortgages, as defaults or delinquencies can affect the cash flows and value of stripped MBS securities.

Benefits of stripped MBS

Despite the risks, stripped MBSs offer several potential benefits for investors:

Customized risk exposure

One of the key advantages of stripped MBSs is the ability to customize risk exposure. By investing in either principal-only strips or interest-only strips, investors can tailor their portfolios to reflect their risk tolerance, investment objectives, and market outlook. This flexibility allows investors to allocate capital strategically based on their expectations of interest rate movements and prepayment speeds.

Diversification opportunities

Stripped MBSs can also provide diversification benefits within a portfolio. These securities have unique risk-return profiles compared to traditional fixed-income investments, such as bonds or plain vanilla MBSs. Including stripped MBSs in a diversified investment strategy can help spread risk across different asset classes and enhance overall portfolio resilience.

Potential for enhanced returns

Depending on market conditions and investor strategies, stripped MBSs have the potential to generate attractive returns. Skillful management of interest rate forecasts, prepayment expectations, and market timing can lead to capital appreciation and income generation for investors in principal-only and interest-only strips.

The bottom line

In conclusion, stripped mortgage-backed securities (MBSs) offer investors a unique opportunity to tailor their investment strategies based on their risk preferences and market outlook. By dividing cash flows into principal-only strips and interest-only strips, investors can customize their exposure to interest rate fluctuations, prepayment speeds, and market conditions.
While stripped MBSs come with risks such as interest rate risk, prepayment risk, and market and credit risk, they also offer potential benefits including customized risk exposure, diversification opportunities, and the potential for enhanced returns.
Investors should carefully assess the risks and benefits of stripped MBS investments and consider their individual financial goals and risk tolerance before incorporating these securities into their investment portfolios. Overall, understanding the dynamics of stripped MBSs is essential for making informed investment decisions and optimizing risk-return profiles.

Frequently asked questions

What are stripped MBS?

Stripped MBS are securities that separate principal and interest payments from mortgage-backed securities.

How do principal-only strips work?

Principal-only strips offer a known dollar amount but uncertain payment timing, affected by interest rates and prepayment speed.

What are interest-only strips?

Interest-only strips generate higher cash flows initially, diminishing over time based on interest rate movements.

How are stripped MBSs affected by interest rate changes?

Interest rate changes impact stripped MBSs by influencing the prices of principal-only and interest-only strips.

What factors should investors consider with stripped MBS?

Investors should consider interest rate trends, prepayment speeds, and their risk tolerance when investing in stripped MBS.

Key takeaways

  • Stripped MBS separates principal and interest payments in mortgage-backed securities.
  • Investor profitability hinges on correctly predicting interest rate movements.
  • Principal-only strips and interest-only strips offer different risk and return profiles.
  • Interest rate changes significantly impact the value of stripped MBS components.
  • Investors should assess their risk tolerance and market outlook before investing in stripped MBS.

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