Quick Question… i just saw a question that said the faster the payments are made on a principle only mortgage strip, the higher the investors return. How is this so? The way I see it is if the rates are higher prepayments will be lower therefore the loan will be outstanding longer causing a higher return? I am guesssing it has something to do with no interest being recieved. Can someone answer?
We would like to hear the question, but the general idea is as below. when are faster payments made ? - when the interest rates are low. So IR low -> prepayments -> principal received faster than expected -> high yield on PO Strips.
i haven’t read this section yet, but ihave a thought. Since the strip is essentually a zero coupon bond then it will have to be issued at a discount (the return is acreated over time). if priced at a discount the strip with have an inital expected YTM… BUT the early payments will shorted the average live, in turn causing a higher return.
it’s easy- say you lend me 8 bucks and agree to pay me back 10 bucks in, i dunno, a year. no interest payments, you’ll just pay me back 10 bucks. (this feels like a zero coupon bond now doesn’t it- no interest payments, issued at a discount). would you rather me pay you back tomorrow or in a year? i think you know the answer to that- you could reinvest the $$ tomorrow and clearly it’s better to get paid now vs later. think of me paying you back come exam time with PO stuff- you want your money and you want it now! IO’s are the opposite. you’re getting interest payments so you want whoever is paying you to pay off that principal nice and slow so you keep on getting lots of interest payments. moral of the story- get paid, greed is good.
haha i just read my thing above and i said you lend me the $$ but then i said you pay me back. i really am greedy! i think you get the idea though. if you make the $2 in a year, your return is $2 over a year’s time. if you make back $2 in a day, annualize that return and now you’re making nice money. PO- paid off? this is good, faster is better.
PO - Principal Only
Yes bannisja has explained this well. With IO’s if interest rates go up then less people are likely to refinance their mortgage so prepayments wont increase, so the IO increases in value with prepayments decreasing. With PO strip, because you aren’t getting paid the interest all you care about is the principal. It doesn’t matter whether it takes 10years to get your money back or 1& month, you’ll still get the same. in 10years, the money will be worth less due to inflation, and there’s the loss of being able to reinvest the money etc etc.
thanks guys