Interest only (IO) and principal only (PO) CMO bonds are obtained by stripping the interest cash flows from the principal cash flows of mortgage collateral. The interest cash flows form one bond, which is the IO. The principal cash flows form a second bond, which is the PO. This is illustrated in Exhibit 1.
With an IO and PO CMO structure, all interest cash flows go to the IO. All principal cash flows go to the PO. The shape of the region indicating principal payments is determined by the rate at which underlying mortgages prepay. This exhibit assumes 30-year fixed mortgages, most of which typically prepay within ten or fifteen years.
Prepayment risk tends to be extreme for IO’s and PO’s, with one benefiting when the other suffers. This is because
- Except for the minor uncertainty of servicing fees, total payments to a PO are fixed. But the timing of those payments is uncertain. Prepayments are desirable because the holder of the PO receives the money earlier.
- Total payments to an IO are not fixed. Prepayments are undesirable because they reduce future interest payments.
Because prepayments are sensitive to interest rates, the value of a PO tends to rise (often dramatically) with declining interest rates. The value of an IO responds in the opposite manner. POs tend to have very high durations. IOs tend to have significantly negative durations.