Interest-Only (io) or Principal-Only (po)

5. As a manager of a savings institution, you must decide whether to invest in collateralized mortgage obligations (CMOs). You can purchase interest-only (IO) or principal-only (PO) classes. You anticipate that economic conditions will weaken in the future and that government spending (and therefore government demand for funds) will decrease.

1. Given your expectations, would IOs or POs be a better investment?

Investing in POs would be a better. A PO pays no coupon, but receives principal payments from amortization and prepayments. Some mortgage securities are created so that investors receive only principal payments generated by the underlying collateral. On the other hand an IO pays a coupon only based on a notional principal, it receives no principal payments from amortization or prepayments. Notional principal does not have any cash flows but shadows the principal changes of the original tranche, and it is this principal off which the coupon is calculated.

When anticipating that economic conditions will weaken in the future and that government demand for funds will decrease, interest rates are likely to decrease. This would result in mortgage prepayments, which causes interest payments on those mortgages to be terminated. In purchasing a PO security, investors pay a price deeply discounted from the face value and ultimately receive the entire face value through scheduled payments and prepayments. The market values of POs are extremely sensitive to prepayment rates and therefore interest rates. If interest rates are falling and prepayments accelerate, the value of the PO will increase. So I may earn some more.

1. Given the situation, is there any reason why you might not purchase the class of CMOs that you selected in the previous question?

Yes, there is prepayment risk so that I may prefer to avoid any investment in IOs classes CMOs.

When government demands for funds decreases it will impact on interest rate that interest rates decline. When interest rates decrease prepayment rates increase, which is the early repayment of a loan by a borrower, in part or in full, often as a result of optional refinancing to take advantage of lower interest rates. I should be mindful for investing in IOs that if prepayment rates are high, I may actually receive less cash back than I initially invested.