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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.
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IO and PO CMO
Structure |
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With an IO and PO CMO structure, all interest cash flows go to the IO. All principal cash flows go to the PO. |
Prepayment risk tends to be extreme for IO's and PO's, with one benefiting when the other suffers. This is because
Total payments to a PO are fixed—all that is uncertain
is the timing of those payments. 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.
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