PO strips question

Principal-only strips are sold at a considerable discount to par. How come?

Principal-only strips are like zero coupon bonds that pay no interest. Zero-coupon bonds are sold at a discount (so the only return a zero-coupon bond holder earns is through the difference between par value and selling price = discount)

eighty, But PO strips are not really like zero coupon bonds because I don’t think there is just one balloon payment at the end (correct me if I’m wrong). PO strips are just the principal portion of each amoritized loan payment (which consist of both principal and interest). The text says that as rates go down, the speed of principal payments (PO strips) goes up, which to me implies that the principal payments (and prepayments) are made throughout the life of the Strip–which does not resemble a zero coupon bond’s characterstics.

You’re correct, the show. That’s why it’s detrimental when rates decrease for a principal strip holder because that increases prepayments and reduces the life of the tranche. An Accrual tranche would be more similar to a zero-coupon bond.

In am amortising loan like Mortgages, in the initial years you pay more interest and less principal. But as years pass, the amount of principal increases and interest decreases. That’s why, POs are sold at a considerable discount to par, because the amount of Principal to be recd now is very little.

JP_RL_CFA, I dont believe this is correct. Since POs are sold at a discount, when interest rates decrease, meaning prepayment increase, the yield on POs will increase… Imagine you buy $100 worth of MBS, at discount, for $80 and interest rates decrease over night, and then next day you get $100 for your $80… It’s the IOs that are sensitive to decreases in interest rates, since the high yield will be refinanced down with lower yield and the investor will miss out on his higher yield due to prepayment.

JP is correct. when interest rates decrease - what happens? Folks refinance their loans. which means entire principal gets paid at 1 shot. The PO tranche owners expected to hold the tranche for a long period of time, but now it all comes to them immediately.

Nope, JP is wrong. PO owners always benefits when rates fall and prepayments increase. They get their profits out of the initial discount. Falling rates are not detrimental to PO tranche The payments to them would increase and they can re-invest these early payments earlier and get more out of it overall . PO tranche benefits from falling rates , while IO tranche gets hit , because early payments reduce prinicpal balances on the passthru securities and shorten the average life .Ultimately the benefit to IO is in longer average life , while benfit to PO tranche is shorter average life

^ Janakisri serious? CPK is right. The only addition that confirm the loss to PO owners is that the accelerated received principal due to early repayment/refinancing from a falling interest rate must now be reinvested at the current LOW rate.

PO tranches - contract suddenly, hence effect of a drop in interest rates is pretty serious, in addition to the fact as oal29 has mentioned that the new amounts received must be reinvested at the new lower rate. IO tranches - the effect of interest rate decrease is not as clear. tranche extends - you get interest payments (albeit at a lower rate) for a longer time. however, tranche could cease to exist because of the effect that it might get completely paid off. So impact is not clear.

Out of the coupon payments , THE PO owners make NO money , other than the amortization of their loan . The payments to the PO are ENTIRELY pricncipal and NO interest . The interest payment to the PO is like that on a zero-coupon securty , paid out in the beginning in the form of a discount on their investment So they do NOT benefit from a lengthy life on the passthru. And they do benefit from a shorter life And they do benefit big time if prepayments accelerate , their amortization is rapid , and more money flows to them that was not planned Falling interst rates is a bummer , but re-investment of early payments is “free money” : They did not expect it at the planned pre-payment rate based on steady interest rates

“tranche extends - you get interest payments (albeit at a lower rate) for a longer time.” Not true: the coupon rates to each tranche , including IO , are set in the indenture and stay fixed ( at the coupon rate for that tranche ) . So the longer the interest rates stay high , the more IO tranche benfits because they get their income , which is fixed at the coupon rate , for a longer TIME ( pre-payments stay steady or even reduce as rates go higher )

was on the wrong track. (and had got the effect backwards). Thanks, Janakasri for the correction. Correct picture for reference… (also to get it back in right). PO ========== rates drop, PO security - gets back principal in full, earlier due to speedy pre-payments. cash flow improves. So PO Price increases when rate declines. rates increase - prepayments slow down, cash flow to PO deteriorates (longer time to receipt of payments). Along with the higher discount rate --> this means PO price falls when rates increase. IO =========== IO gets no principal. IO investor wants slower prepayments since he receives interest on the Principal outstanding. When prepayments are made - IO investor gets less interest. If prepayments are too fast - IO investor may not recover amount paid, even if he holds security to maturity. When rates drop - prepayments accelerate -> results in lower cashflows to the tranche. While this is discounted at a lower rate - net effect is a drop in price of IO tranche. If rates increase - higher cashflows occur due to slower prepayments, but this is discounted at the higher rate. So effect is either an increase or a decrease. (depends on situation).

CPK, Correct. The value of the principal strip increases when int rates decline but you can only realize that profit if you sell out of the tranche otherwise, all it does is speed up your cash flow, which could or could not be a good thing depending on the preference of the investor.

JP: I don’t think that’s right. If prepayment of principal increases the PO tranche owners immediately see a gain on their investment . Their cash flow increases immediately. They may or may not get a better price on their investment by selling out , but isn’t that besides the point ? Their present investment is paying out better than hoped earlier . In fact if all issuers of the securities paid out the remaining principal in the very first period after the investment , the PO tranche owners could realize their entire planned profits over the average life in ONE period . That would be an extremely HIGH holding period return, and the price of the tranche would be ZERO ( no principal left in the tranche to amortize)

From Investopedia: “The yield on a PO strip depends on the prepayment speed of the underlying loan. The faster the principal is repaid, the higher the yield an investor will receive. Since the investor benefits from faster repayment speeds, he or she is protected from contraction risk. This means that, unlike a usual bond, the investor will benefit from decreases in the interest rate.” http://www.investopedia.com/terms/p/postrips.asp

I think that everything that cpk said at 1032am is accurate and I checked the text for this. However getting back to the original question, can we now understand why PO strips are sold at a considerable discount to par?

As someone mentioned above - it is a zero coupon bond receives NO Interest. (which by definition is a heavily discounted bond).

cpk123: I talked of a zero-coupon bond earlier, which someone thought was not right =)

I don’t understand why u would face contraction risk by getting the cashflows earlier. I thought getting the cash flows earlier was contraction risk. You are receiving the same amount of money either way. Whether they prepay faster or slower, u still receive the same amount but I see where it could be very beneficial to get the money quicker and reinvest it regardless of what rates are. CPK - with a zero coupon bond u don’t receive prepayments, hence no cashflow until the end of the maturity but it does have the same characteristic being of bought at a discount. Anyway, I think we killed this topic. Bottom line is for test day, int rates go down, good thing for principal bondholders.