The holder of an interest-only strip will receive less total payments when prepayment rates are higher since interest is only paid on the outstanding principal amount, which is decreased by prepayments. Anyone understand this?
When prepayments occur - the amount of outstanding principal on the MBS Loan is rapidly reduced. Prepayments usually occur when Interest rate environment is lower. When the Principal is rapidly reduced because of the prepayment - interest that is due on the remaining principal (outstanding principal) is reduced.
CP is right. It’s a simple concept, don’t get lost in the lingo. Keeping it simple: - interest is calculated based on principal amount outstanding on loan - prepayments reduce principal oustanding on loan - interest is therefore calculated on a reduced amount - interest ~= coupon, therefore bond holder receives lower coupon
You are all right. Gazhoo, just keep it simple. Don’t think it out too much. As long as prepayment rates are higher, the outstanding principal balance will be greatly decreased and hence interest would significantly be lesser for holder of an interest-only strip . Thanks.