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Reading 55: Mortgage-Backed Sector of the Bond Market-LOS j

Session 15: Fixed Income: Structured Securities
Reading 55: Mortgage-Backed Sector of the Bond Market

LOS j: Explain the investment characteristics of stripped mortgage-backed securities.

 

 

 

How is the price of a principal-only mortgage strip affected by declining mortgage rates in the market? The price of the principal-only strip:

A)
decreases.
B)
increases.
C)
is unaffected.



 

When mortgage rates decline, prepayments are expected to increase. Therefore, the principal-only strip investor gets payments sooner increasing the value of the PO.

Interest only (IO) strip cash flow:

A)

are the same throughout the life of the security.

B)

starts out small and gets bigger over time.

C)

starts out big and gets smaller over time.




IO strip cash flow starts out big and gets smaller over time.

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Principal-only strips are:

A)

could be sold at a discount or a premium, depending on economic conditions.

B)

sold at a considerable discount to par.

C)

sold at par.



Principal-only strips are sold at a considerable discount to par.

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Which of the following best describes a stripped mortgage-backed security (MBS)? A stripped MBS is a security:

A)
that provides no interest payments.
B)
whose distribution of principal and interest has been altered from a pro rata distribution to an unequal distribution.
C)
whose distribution of principal and interest has been altered from an unequal distribution to a pro rata distribution.


With a passthrough security, interest and principal payments generated by the underlying mortgage pool are allocated to the bondholders on a pro rata basis. This means that each passthrough certificate holder receives the same amount of interest and the same amount of principal. Stripped mortgage-backed securities differ in that principal and interest are not allocated on a pro rata basis.

TOP

Which of the following is most accurate regarding the investment characteristics of a principal-only (PO) mortgage strip?

A)
The slower the prepayments the higher the investor's return.
B)
The faster the prepayments the higher the investor's return.
C)
The lower the coupon the higher the investor's return.



For a principal mortgage strip the investor does not receive interest but only the principal. Therefore, the sooner the investor receives the principal the higher the return.


TOP

How is the price of an interest-only mortgage strip affected by declining mortgage rates in the market below the contract rate? The price of the interest-only strip:

A)
decreases.
B)
may increase or decrease.
C)
increases.



When mortgage rates decline, prepayments are expected to increase. This results in a deterioration of the expected cash flows from an interest-only strip.

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