hi, can someone please explain why principal only strips are sold at a discount to par? Thanks
There is zero interest involved… just the principal… So you discount the principle payments and come up with a PV that is less than Par value… Make Sense?
you mean an incentive for people to buy is to reduce the price given that they are not receiving any interest? however, thus this concept applies as well to interest only strips?
A Principle only strip is like a zero coupon bond in a sense… If the par value is $1000 and you dont recieve the payment until 1 year then the PV is going to be less than $1000 due to the discount… Im sure you understand this…
ok or hope i understood… you are saying that you dont receive the payment because there is a prepayment then the present value is going to be lower… ok?
I will sell you $1000 face value worth of principal. All that you are ever going to get is $1000. You might get it in 30 years or you might get it tomorrow. How much will you pay? I dunno, but surely less than $1000.
And to add to JVD’s comments… Prepayments will increase the value of a Principle Only Strip… Because you would collect your principle (or Future Value of the Investment) much sooner… So as interest rates decrease the Principle only strips tend to increase in value… Therefore if you were to expect interest rates to decrease you would buy a PO Strip…It works in the opposite direction for a IO Strip… If you expect interest rates to rise you would buy the IO Strip knowing that people will refinance less and your investment will yield more interest over time… Hope that makes more sense…
thank you so much.