Schweser states that POs (Principal Only strips) have negative key rate durations during early years which turn to positive in later years. How? As rates drop, the prepayments increase, which drive the value of PO up. This should mean positive key rate D. how is this negative key rate D. I think what it means is that in the short to medium term the PO investor does not fully recoup the amount invested. Please shed some light if you can.
That’s a tough one but maybe resolved in http://www.analystforum.com/phorums/read.php?13,664320,668992#msg-668992
If rates decrease and prepayments accelerate than the issue of reinvestment is a problem because you have large prepayments that need to be reinvested at ever lower rates. Hence in the early years duration can effectively be negative because of the issue of reinvestment concerns. Subsequent to the passage of time however these large prepayments are less and less of a concern because you have already captured the value from the investment.