hard · Asset-Backed Securities
Why does an Interest-Only (IO) strip have 'negative duration' in many interest rate scenarios?
- Because IO strips are typically issued as floating-rate notes with LIBOR caps
- It reflects the 'burnout' effect of the underlying mortgage pool
- When interest rates fall, prepayments accelerate, reducing the total interest cash flows and causing the bond price to drop
- When interest rates rise, the discount factor increases more than the coupon income
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