Fundamental MBS Structuring Techniques: Divisions of Interest
As with the division and structuring of principal cash flows, interest cash flows can also be altered and redirected within a structure. The factors driving the structuring of interest are identical to those in principal structuring discussed in the preceding chapter. The goal is to create bonds that, by appealing to different segments of the fixed income investment community, maximize the proceeds generated by creating and selling the deal. By redistributing interest within the deal, bonds can be created with different degrees of exposure to interest rates and/or prepayment speeds. As examples, the following bonds can all be structured off either a pool of collateral or a parent tranche:
• Floaters. A bond where the interest adjusts (or “floats”) with a benchmark index have minimal exposure to changes in interest rates (i.e., its duration is very short).
• Principal-only (PO) tranches. Bonds that pay no coupon interest to the holder. Sold at a deep discount to investors, its returns are based on the rate at which principal is returned to the investor. These bonds typically have very long and volatile durations, since their prices are affected not only from the impact of a different discount rate on the cash flow’s present value, but by changing prepayment speeds.
• Interest-only (IO) tranches. Bonds that pay only interest to the investor, based on the remaining balance of a notional principal amount. These ...