Interest only strips are mortgage-backed securities that pay you the interest portion of a pool of home loans and nothing else. There is no principal coming back at maturity, the cash flow shrinks as borrowers pay down or pay off their mortgages, and the price moves in the same direction as interest rates rather than against them. That last feature is why institutions use them: an IO strip gains value when a conventional bond portfolio is losing it.
How the Security Is Built
Every mortgage payment contains two components, interest and principal. Stripping splits the cash flow from a securitized pool of mortgages into two separate securities. The IO strip collects all the interest. The principal only (PO) strip collects all the principal, including scheduled amortization and any early payoffs. The two streams never cross.
Most IO strips come out of programs run by government-sponsored entities. Fannie Mae issues them through its Stripped Mortgage-Backed Securities program, where excess servicing above 25 basis points is pulled from loans backing Fannie Mae MBS.1Fannie Mae. SMBS – Capital Markets Ginnie Mae runs a comparable program and guarantees timely payment of principal and interest on each class.2Ginnie Mae. Stripped MBS IO strips also appear as regular interests inside Real Estate Mortgage Investment Conduits, where the strip conveys a specified portion of the interest on the REMIC’s qualified mortgages.3Federal Register. Interest-Only REMIC Regular Interests
Notional Principal and Why Nothing Is Returned at Maturity
An IO strip has no principal that gets repaid to you. It references a notional balance, which is the outstanding loan balance in the underlying mortgage pool, used only to compute how much interest you receive each month. Cash flow equals the coupon rate multiplied by whatever notional balance is left. A REMIC IO can carry a specified principal amount of zero; the holder is entitled only to a share of the interest stream.3Federal Register. Interest-Only REMIC Regular Interests
That is the fundamental departure from most fixed-income products. Your entire return comes from interest on a shrinking balance, and if that balance disappears too fast, the total return can go negative. No par value is waiting for you at the end.
Prepayment Is the Central Risk
The interest you collect each month depends on how much principal is still outstanding in the pool. Regular amortization shrinks that balance predictably, and the price of the strip already reflects that decline.
Prepayment is the unpredictable part. When homeowners sell, refinance, or pay extra toward the loan, principal disappears immediately, and every dollar that vanishes early is a dollar that will never generate another interest payment. Faster-than-expected prepayments cut the interest stream short.
The market prices IO strips against an assumed prepayment speed. The industry benchmark is the PSA model, where 100 percent PSA starts at a 0.2 percent monthly rate, ramps up by 0.2 percent each month, and levels off at 6 percent annually in month 30. Faster scenarios such as 200 percent PSA double those rates. The value of your strip depends on which scenario actually plays out.
Why the Price Rises When Rates Rise
A traditional bond loses value when rates climb because its fixed coupon looks worse against newly issued paper. IO strips do the reverse, and prepayment behavior is the reason.
When rates fall, homeowners refinance out of higher-rate mortgages in large numbers. That refinancing wave is a mass prepayment event. Principal disappears from the pool, future interest payments vanish, and the strip drops in value. You bought a multi-year interest stream, and it just got cut off.
When rates rise, borrowers sit still. Refinancing a low-rate mortgage into a higher-rate one makes no sense, so prepayments slow, the balance persists longer than the market had priced in, and the strip generates more total interest than expected. Its value increases.
Moving in the same direction as rates is called negative duration. Positive-duration securities lose when rates rise; negative-duration securities gain. At creation, IO strips typically carry strongly negative duration because refinancing behavior is so tightly linked to the rate environment. That is what makes them useful hedges against portfolios of conventional bonds.
Negative Convexity and Asymmetric Payoffs
The price-rate relationship is not a straight line. When rates drop past the point where a refinance saves a homeowner around 50 basis points, prepayment speeds can jump from single digits to well above 40 percent. The strip’s value falls much harder than a simple duration figure would predict.
On the other side of the curve, when rates are already high, prepayments settle into a narrow band of roughly 4 to 9 percent, driven mostly by home sales and cash-out refinances rather than rate-driven refis. Further rate increases produce diminishing gains for the IO holder because prepayments are already about as slow as they get. The result is negative convexity: the downside from a rate decline is steeper than the upside from an equivalent rate increase. Misjudging a falling-rate environment costs more than misjudging a rising one.
Credit Risk on Agency Versus Non-Agency Strips
For IO strips issued through Ginnie Mae, Fannie Mae, or Freddie Mac programs, direct credit risk is largely removed. The agencies guarantee timely payment of principal and interest on the underlying MBS, so investors are insulated from losses caused by individual borrower defaults.2Ginnie Mae. Stripped MBS In agency MBS, the risk of default on the underlying mortgages is borne by the guaranteeing agency, not the investor.4Federal Reserve Bank of New York. Understanding Mortgage Spreads
Defaults still reach the IO holder indirectly. When a defaulted loan is liquidated or modified, its principal is retired, which functions like a prepayment: the interest from that loan ends. Non-agency IO strips, backed by private-label MBS with no government guarantee, add full credit risk on top of prepayment risk and are considerably more volatile.
Who Actually Buys These
The market is overwhelmingly institutional. Banks, insurance companies, mortgage servicers, hedge funds, and specialized fixed-income managers hold most of the outstanding paper. Mortgage servicers are natural buyers because mortgage servicing rights share the same risk profile: income tied to the outstanding balance of mortgage pools, gains when rates rise and prepayments slow, losses when refinancing surges.
Retail access exists on paper but faces real barriers. A broker-dealer recommending an IO strip has to satisfy FINRA Rule 2111, which requires a reasonable basis for believing the investment is suitable given the customer’s risk tolerance, experience, time horizon, and liquidity needs.5FINRA. FINRA Rule 2111 (Suitability) FAQ Given the complexity and the potential for negative total returns, most firms restrict these products to institutional or high-net-worth accounts. Retail investors who want exposure usually get it indirectly through mutual funds or ETFs that hold IO strips inside a broader mortgage strategy.
Tax Treatment and the Phantom Income Problem
Income from an IO strip is taxed as ordinary income, not capital gains. Under the Internal Revenue Code, buying a stripped coupon is treated as if you bought a bond issued at a discount. The gap between what you paid and the total payments you expect is classified as original issue discount.6Office of the Law Revision Counsel. 26 USC 1286 – Tax Treatment of Stripped Bonds You include that OID in gross income over the life of the security on a constant-yield basis, whether or not the cash has actually arrived.7Office of the Law Revision Counsel. 26 USC 1272 – Current Inclusion in Income of Original Issue Discount
Because accrual is a formula, not a receipt, there are stretches when your taxable income exceeds the cash in your account. Investors call this phantom income. The gap tends to be worst in early periods when accrual is front-loaded but cash flows have not ramped up, or when a prepayment surge disrupts the expected schedule. Buying at a premium lets you amortize that premium to reduce reported income; buying at a discount increases the accrual.
Issuers report OID to you and to the IRS on Form 1099-OID.8Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID IRS Publication 1212 gives the tables and guidance for calculating OID on specific instruments, including stripped coupons.9Internal Revenue Service. Publication 1212 – Guide to Original Issue Discount (OID) Instruments Most holders rely on the custodian’s tax reporting or specialized software, because tracking OID by hand across a mortgage pool with shifting prepayment speeds is not realistic.