Why do Interest Only (IO) strips exhibit negative duration characteristics at yields below the mortgage coupon rate?

Question

BlackTom AI · Accepted Answer

Question restatement: Why do Interest Only (IO) strips exhibit negative duration characteristics at yields below the mortgage coupon rate?

Option provided: 'As rates fall below the coupon rate, the prepayment effect dominates the discount effect—accelerated prepayments reduce the number of interest payments more than lower discount rates increase present value, causing IO prices to fall as rates fall.'

Analysis of the option:
- Core idea: The statement claims that when market yields drop below the mortgage coupon, prepayments accelerate, and the shortening of the interest-payment stream from prepayments outweighs the PV gain from discounting at a lower rate, leading to a price decline for IO strips as rates fall. This aligns with the standard explanation of negative duration for IO strips in certain rate regimes.
- Mechanism details: IOs receive only interest payments (the coupon portion) of the mortgage. When rates decline, borrower prepayments typically speed up as borrowers refinance or pay down outstanding principal. Prepayments reduce the number of future interest payments that the IO would receive, which reduces the length and size of the cash-flow stream. Although a lower discount rate tends to increase the present value of future cash flows, the IO’s value is heavily driven by the timing and magnitude of those prepayments. If prepayments shorten the expected cash-flow stream enough, the overall price can move down when rates fall, yielding a negative effective duration.
- Correctness check: The statement correctly identifies (a) the onset of prepayment acceleration when rates fall below the mortgage coupon, and (b) the competition between the prepayment-driven decrease in interest cash flows and the discount-rate-driven PV uplift. It concludes that prepayment effects can dominate, causing IO prices to fall as rates fall, which is the core intuition behind negative duration in this scenario.
- Potential edge cases to consider: The magnitude of negative duration depends on coupon levels, prepayment models, and how far yields fall relative to the coupon. If the rate drop is modest or prepayment incentives are weak, the discount effect might still dominate, reducing the strength of the negative duration assertion. However, the option captures the widely taught mechanism for negative duration in IO strips when yields dip below the mortgage coupon.

Why this option is correct (in context): It articulates the essential trade-off for IOs: prepayments shorten the cash-flow horizon, which can outweigh the benefit of discounting at a lower rate, leading to price declines as rates fall. This explanation matches standard fixed-income theory for IO strips and their negative duration behavior under the specified condition (yields below the coupon).

Why there are no other options to evaluate (per the provided data): The dataset presents no additional answer choices to compare, so there is no alternative reasoning to contrast against. If there were multiple options, we would assess each for accuracy and identify the best-supported explanation.

BU.231.710.51.FA25 PoP Quiz - 3 (Week 6)

Why do Interest Only (IO) strips exhibit negative duration characteristics at yields below the mortgage coupon rate?

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