medium · Asset-Backed Securities asset-nuances

If a CMBS Interest-Only (IO) tranche is valued based on a 'notional' balance, how does an increase in the underlying pool's default rate affect the IO investor?

1. It increases the IO's value because defaults extend the life of the pool.
2. It increases the yield because the investor receives higher 'default interest' penalties.
3. It has no effect as IO tranches are only sensitive to voluntary prepayments.
4. It decreases the IO's value because the notional balance declines faster.

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