I’ve come across some interesting structured financial products and I’m trying to understand the risks. For example, currently interest rates are very low. If you can buy an IO strip (negative duration) in this environment and interest rates don’t go down, what are the risks associated with the upside? Are there any besides the typical credit risk, interest rate risk on the downside, etc? In this environment, why isn’t everyone loading up on them?
If anyone has some insight, I’d love to hear. And if you have insight on how to price them as a future investment, I’m all ears as well.
Can you explain that? That’s what I’m trying to understand. Really the only part of IO’s I know to look at is PSA (and forecasted PSA). Would the extension risk be the problem with IOs? If it’s priced at a PSA occuring at 4% market rates and rates go up to 8%, that security is likely (depending on region, etc) to have a very slow PSA positively affecting the value of the security and life of interest payments. But I don’t know what a ‘normal’ haircut or premium people pay for an IO strip currently.
Surely you could construct a portfolio with negative duration using IOs and more traditional yield paying component. if rates fall the yield would cusion the blow somewhat. if rates rise you reap the shit from the neg duration portfolio.
Note - i havent really thought this through just a thought.
I haven’t looked at this asset class in detail, but isn’t this more or less like just buying mortgage-backed bonds? That is, you just get fixed payments unless people default.
The low interest rate environment is one thing to consider. However, I would be especially wary of dealer mark up for products like this, due to the many opaque layers of pricing.
If you bought into IO’s currently, you’re locking in extremely low interest rate on the one hand, on the other hand, due to low interest rate environment, there are still prepayment levels that will exceed what’s modeled by PSA’s, and you might not even earn enough interest to cover your cost basis before the pool is paid off. It’s in my opinion that the PSA’s that people were using the past two years were too slow.
My experience was that I basically bought a bunch of support tranches at a deep discount, didn’t care too much about the rat of the interest component on the underlying mortgages, with the intent of getting of getting my principal back a few years earlier than modeled, and for the bulk of them I did, which generated decent alpha on a low risk position (agency CMO’s).
Also depends on how quickly interest rates go up, where you could figure the ‘extension’ on your IO’s more than offsets the new higher rate you’d have to discount them for.
If you were wealthy and risk averse, you’re better off putting the same capital in a high yield money market.
The discount effect is something I hadn’t thought about. The benefits of the slowing PSA’s eventually get outweighed by the increasing discount rate, resulting in an appreciation in price and then depreciation as rates move even further up. thanks for the insight lockheed
And for Ohai, it’s basically you get interest payments and the other party gets the principal payments. IO will benefit when PSAs slow and PO will benefit when PSAs increase. As a result, it has a different type of price violatilty than mortgage bonds because it moves with interest rates in the same direction (Until the discount rate exceeds the benefit of slowed PSAs)
The first thing you need to think about is where IO strips are derived from. Most likely agency pass throughs or agency CMOs. For pass through MBS, the pricing considers prepayments and has a constant prepayment rate assumption. So even if market rates exceed the coupon on your IO, you won’t have price deterioration. Because there’s an assumption of prepayments, there’s actually more principle to base the interest payments on as rates go up. There’s also an extension of payments. Of course the price of your IO will fall as time goes by but only due to the amortization schedule, assuming rising rates.
No credit risk if you’re looking at agency IOs/POs. IOs are likely in demand but pricing probably reflects rising rate expectations. Also, this part of the FI market is pretty much filled by institutional players only. My old director used to run a mortgage portfolio and she considered a par trade $5mm. When I traded Treasury/Agency paper, $25mm-$50mm trades were common. Largest trade I ever did was a $150mm Treasury trade. I must have counted the zeros at least a dozen times before executing the trade.
As lockheed mentioned, the vintage of the MBS that the IO/PO is based off of is super important. However, rates hit such a bottom in 2012 that everyone that could refinance probably has already. IOs have large negative convexity but can become positively convex if interest rates drop far enough to push prepayments close to their maximum rate. At that point, any further drop in rates has limited impact on the IO cash flows and limited potential to force price down further. The IO then has limited price downside, but significant upside.