I had suggested constructing a stripped MBS with Interest Only and Principal Only, as interest rates fall the PO becomes less valuable while the IO becomes more valuable.... ...hence Investors can create a combination of these. In a PO, a fixed amount of principal is returned to the investor, but the timing is uncertain. A high rate of prepayments on the underlying pool leads to the principal being received early (which is, of course, good news for the holder of the PO). A low rate of prepayments on the underlying pool delays the return of the principal and reduces the yield provided by the PO. In the case of an IO, the total of the cash flows received by the investor is uncertain. The higher the rate of prepayments, the lower the total cash flows received by the investor, and vice versa. Is this convincing?
