How are principal-only (PO) strips priced and why do they have extremely high duration?

Question

AcadiFi · Accepted Answer

Principal-only (PO) strips receive all principal payments from a mortgage pool and none of the interest. While PO holders always receive full par value eventually, the timing of those payments creates significant interest rate sensitivity.

**PO Pricing Logic:**

PO strips are purchased at a discount to par. The return comes entirely from the speed at which principal is returned:

PO Value = Sum of PV(scheduled principal + prepayments)

Since there are no coupon payments, the PO is essentially a zero-coupon instrument with uncertain maturity. This creates extremely high duration.

**When Rates Fall:**
1. Prepayments accelerate → principal returned sooner
2. Faster return of par value at a higher discount rate → higher PV
3. Additionally, the lower discount rate further increases PV
4. **Both effects reinforce each other** → PO value increases sharply

**When Rates Rise:**
1. Prepayments slow → principal returned later
2. Longer wait for par value → lower PV
3. Higher discount rate further reduces PV
4. **Both effects reinforce each other** → PO value decreases sharply

**Numerical Example:**
PO strip on $100M mortgage pool, purchased at $72M (72% of par).

| Rate Scenario | Prepayment Speed | Avg Life | PO Value | Return |
|---|---|---|---|---|
| Rates -200 bps | 500 PSA | 2.1 yrs | $93M | +29.2% |
| Rates unchanged | 175 PSA | 8.5 yrs | $72M | 0% |
| Rates +200 bps | 80 PSA | 16.3 yrs | $54M | -25.0% |

**Why Duration Is So High:**

1. **Zero-coupon effect**: Like zero-coupon bonds, POs have duration approximately equal to their average life (no coupons to shorten duration)
2. **Prepayment amplification**: Rate changes affect both the discount rate AND the average life simultaneously
3. **Positive convexity**: The PO benefits from both effects when rates fall and suffers from both when rates rise

Typical PO effective duration: 15-25 years (versus 5-8 for a standard MBS pass-through)

**IO and PO Relationship:**
IO + PO = Original MBS Pass-Through

| Component | Duration | Rates Fall | Rates Rise |
|---|---|---|---|
| IO | Negative | Loses value | Gains value |
| PO | Very positive | Gains value | Loses value |
| Combined (Pass-Through) | Moderate positive | Moderate gain | Moderate loss |

**Who Uses PO Strips?**
- Investors wanting leveraged exposure to falling rates
- Portfolio managers needing to increase duration efficiently
- Hedgers offsetting negative duration positions

**CFA Exam Focus:** Know that PO strips have very high positive duration and positive convexity, and that they benefit when prepayments accelerate.

Practice MBS strip analysis in our CFA fixed income question bank.

How are principal-only (PO) strips priced and why do they have extremely high duration?

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