IOs and POs

One way to slice a pool of mortgages is into securities that receive only interest payments (IOs) and securities that receive only principal payments (POs). The reason for doing this is that the IOs are fairly unique instruments, because they have negative duration. This means that when interest rates rise, the value of the IOs also rise. Most debt instruments have positive duration meaning that when interest rates rise, the value falls. In the mortgage arena, the only other instrument that I know of with negative duration is service contracts.

So what is the issue with IOs?

Well, IOs can protect your portfolio from interest rate risk, but they increase your exposure to default risk. When a mortgage defaults, the IO portion becomes valueless. The PO portion gets whatever can be obtained from a sale of the property, but the IO portion gets nothing.