Among the most basic mortgage-backed securities are "strips". The name is derived from "Separate Trading of Registered Interest and Principal Securities", and refers to the isolation of cash flow from interest payments or principal payments on a pool of bonds. Strips can be created from almost any kind of bond or bond-like asset where cash flow can be split into interest-only (an "IO") and principal-only (a "PO") strips.
This Demonstration explores some of the properties of strips created from pools of mortgages.
The characteristics of the mortgage IO and PO differ. For example, the interest payments on a fixed mortgage are front-loaded, while the principal payments are back-loaded, so the duration of the PO is much longer than the duration of the IO. Further, increases in prepayment rates are very good for holders of POs, as they get their principal back immediately when somebody refinances, while these prepayments are bad for holders of IOs, as the refinancing ends their cash flow entirely.
This Demonstration shows how these cash flows and the resulting value of the strip change with the prepayment rate. The Demonstration allows the user to change the mortgage interest rate independently to see how cash flows change. In reality, these variables are not independent but are closely linked: prepayment rates increase when interest rates drop and drop when interest rates rise.