Interest-Only (IO) Strip

An IO Strip isolates and securitizes only the interest payment stream from an underlying debt obligation. The holder receives periodic interest payments but has no claim to the principal repayment. This creates a leveraged, pure-play instrument sensitive to interest rate movements and the creditworthiness of the underlying borrower.

The value of an IO Strip is highly sensitive to prepayment speed. If the underlying loans are paid off early (e.g., due to refinancing in a lower rate environment), the future stream of interest payments ceases. This makes IOs negatively convex—their value can decrease sharply when interest rates fall and prepayments accelerate.

IO Strips are typically created through the tranching of Collateralized Mortgage Obligations (CMOs) or other asset-backed securities. Structurers allocate all or a disproportionate share of the interest payments to one tranche (the IO), while creating a companion Principal-Only (PO) Strip that receives all principal repayments.

Due to their unique risk profile, IO Strips serve specific purposes:

• Hedging: Financial institutions use IOs to hedge against prepayment risk in their mortgage servicing portfolios or other interest-sensitive assets.
• Speculation: Traders take directional views on future interest rate stability or volatility, as IO values are highly sensitive to changes in the yield curve.

The price of an IO Strip is not based on a fixed coupon. It is a function of:

• Discount Rates: The prevailing risk-free yield curve.
• Prepayment Models: Projections of how quickly the underlying principal will be repaid (e.g., using the PSA benchmark).
• Credit Spreads: The risk premium demanded for the underlying borrower's credit.

IO and PO Strips are complementary derivatives created from the same cash flow pool. Their risk profiles are opposites:

• IO Strip: Benefits from stable, slow prepayments (higher interest over time). Loses value when rates fall.
• PO Strip: Purchased at a deep discount to face value. Benefits from accelerated prepayments (principal returned faster). Gains value when rates fall.

The primary risk for IO holders. When underlying loans are repaid early (e.g., a mortgage refinance or a crypto loan liquidation), the stream of future interest payments ceases. This causes the value of the IO strip to plummet. This is also known as contraction risk.

IO strips have negative duration. Their value moves inversely to interest rates:

• Rates fall: Borrowers refinance/prepay loans, cutting off interest cash flows → IO value decreases.
• Rates rise: Prepayments slow, extending cash flow duration → IO value may increase. This is opposite to traditional fixed-income bonds.

If a borrower defaults on the underlying loan, the principal may be recovered, but all future interest payments from that loan are lost. In pools with high loan-to-value (LTV) ratios or volatile collateral (e.g., crypto assets), default waves can rapidly erode the IO's value to zero.

The opposite of prepayment risk. If interest rates rise and prepayments slow, the IO's cash flows are extended over a longer period. While this increases duration, it also increases exposure to long-term default risk and delays the return of capital, which can be undesirable for investors seeking shorter-term yield.

In a tranched capital structure (e.g., a Securitization or Structured Product), IO strips are often the most junior claim on interest payments. They are paid only after senior tranches receive their scheduled interest. This makes them first to absorb losses from payment shortfalls.

IO strips are complex derivatives with limited secondary market liquidity. Their valuation requires sophisticated models to forecast prepayment speeds (Prepayment Models) and default rates. Inaccurate models can lead to significant mispricing. They are typically traded by institutional investors, not retail.

The complementary component to an IO strip, representing the right to receive only the principal repayments from the underlying asset pool. While IO strips are sensitive to prepayment speeds, PO strips increase in value when prepayments accelerate, as principal is returned sooner. This creates an inverse price relationship between IO and PO strips derived from the same collateral.

A slice or portion of a pooled financial product, such as a Collateralized Debt Obligation (CDO) or Mortgage-Backed Security (MBS), that has a specific risk and return profile. IO and PO strips are created by tranching the cash flows of these securities. Different tranches have varying priorities for receiving interest and principal payments, which defines their credit risk.

The risk that the underlying borrowers (e.g., mortgage holders) will repay their loans earlier than scheduled, significantly impacting the value of interest-bearing securities. This is the primary risk for IO strip holders, as faster prepayments reduce the total future interest payments, causing the IO strip's value to decline. Modeling this risk is central to IO strip valuation.

A sector of finance that creates complex financial instruments by pooling assets and issuing layered claims (tranches) against the resulting cash flows. The creation of IO and PO strips is a classic structured finance technique used to redistribute risk and create securities with customized exposure to interest rate movements, prepayment behavior, and credit events.

The predefined, hierarchical order in which cash flows from a pool of assets are allocated to different tranches or strip holders. The waterfall rules dictate that interest payments are paid to IO strips before principal is allocated to PO strips or other tranches. This legal structure is defined in the deal's pooling and servicing agreement.

Key measures of a bond's sensitivity to interest rate changes. IO strips exhibit unique characteristics:

• Negative Duration: Their value can decrease when interest rates fall (due to increased prepayment expectations).
• High Negative Convexity: Their price sensitivity to rate changes is not linear, leading to asymmetric risk, especially in a falling rate environment.