Pass through securities vs. principal only strips and interest only strips

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keep_running

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1. In a rising interest rate environment, how can you tell the difference between a pass through securites and a principal only strip?
They both decline in value as interest rates rise, (due to lower prepayment speed I am assuming), but how exactly can you tell the difference between the two MBSs?
2. How come interest only strips rise with interest rates? I would assume that the coupon would become less valuable with a rise in interest rates in time.
Thank you for your help!
 
keep_running wrote:1. In a rising interest rate environment, how can you tell the difference between a pass through securites and a principal only strip?
They both decline in value as interest rates rise, (due to lower prepayment speed I am assuming), but how exactly can you tell the difference between the two MBSs?
Click to expand...
They behave pretty much identically; nothing much to distinguish them.
keep_running wrote:2. How come interest only strips rise with interest rates? I would assume that the coupon would become less valuable with a rise in interest rates in time.
Click to expand...
This happens only when interest rates are low (but rising). When interest rates are low, there’s more likelihood that the loan will be paid off (refinanced), whereupon the I/O becomes worthless. As interest rates rise, there’s less of a chance that the loan will be paid off, so the I/O is worth more, up to a point. When rates are high enough, there’s essentially no chance of a payoff, I/Os start to behave like normal bonds.
I don’t see anything in the Level I curriculum about P/O and I/O strips; why do you ask, pray tell.
 
I had some practice question regarding this material. Will it not be on the test for this upcoming June?
 
There’s nothing in Level I fixed income about P/O strips or I/O strips.
I’d leave it be.
(And I hate that some prep providers don’t review their question banks and remove out-of-date questions. It’s unfair to the candidates to have them worrying about things that are no longer in the curriculum.)
 
Sounds good. Thank you for letting me know!
What should I know regarding passthroughs then? Should I be able to know how the relationship between interest rates and price for passthrough securities?
 
You should know that at high interest rates they behave like normal (option-free) bonds, and at low interest rates they behave like callable bonds.
You should also know that because they pay coupons monthly and because they’re amortizing bonds, they’ll have a shorter (modified or effective) duration than a straight bond with the same coupon rate.
 
Sorry , S2000 Magician I am not able to understand the second paragraph of yours “ You should also know that because they pay coupons monthly and because they’re amortizing bonds, they’ll have a shorter (modified or effective) duration than a straight bond with the same coupon rate. “
Are you relating the life of amortizing bond with the changes in Interest rates ?
so you mean to say that there are 2 types of bond with same coupon rate , first one amortizing , second one non-amortizing , And now interest rates has fallen; so the life of the the first one will be less than second !
 
Ankit Sharma wrote:Sorry , S2000 Magician I am not able to understand the second paragraph of yours “ You should also know that because they pay coupons monthly and because they’re amortizing bonds, they’ll have a shorter (modified or effective) duration than a straight bond with the same coupon rate.“
Are you relating the life of amortizing bond with the changes in Interest rates?
so you mean to say that there are 2 types of bond with same coupon rate , first one amortizing, second one non-amortizing, And now interest rates has fallen; so the life of the the first one will be less than second!
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I’m not talking about the life of the bond; I’m talking about the duration.
The more frequently coupon payments are made, the shorter the Macaulay duration (and, consequently, the shorter the modified duration). Amortizing bonds have shorter Macaulay duration than nonamortizing bonds (and, consequently, shorter modified duration).
I wrote an article on duration that may be of some help here: http://financialexamhelp123.com/macaulay-duration-modified-duration-and-...
 
Sounds good. So pass throughs do not have put options on them (as you were only talking about call options on these bonds).
 
That’s correct: no put options.
Mortgage passthroughs have prepayment options, which are similar to call options: they allow a portion of the bond to be paid off early, at the issuer’s – well, technically, the homeowners’ – discretion.
 
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