A Principal-Only Strip (PO) is a type of financial instrument that gives its owner the right to receive the principal portion of the payments from a pool of mortgages or other loans. Think of a standard loan payment, which is made up of two parts: a slice that goes toward paying down the original loan amount (the principal) and a slice that covers the interest. A PO is created when an investment bank buys a bundle of loans, typically a Mortgage-Backed Security (MBS), and surgically separates—or “strips”—these two payment streams into two distinct securities. The PO gets all the principal payments, while its sibling, the Interest-Only Strip (IO), gets all the interest payments. This process of financial engineering is a form of securitization. Because POs pay no interest, they are sold at a significant discount to their total principal amount, or face value. The investor's return is the difference between this discounted purchase price and the principal they eventually receive.
Imagine you bought a magical apple orchard, but the contract says you only get the trees themselves, not the apples they produce each year. The value of your investment is realized only when the trees are harvested and sold for their wood (the principal). Similarly, a PO investor doesn't receive regular interest income. Instead, they receive cash only when homeowners in the underlying mortgage pool make principal payments. These principal payments come from two sources:
The speed at which these prepayments occur is the single most important variable determining a PO's performance. Faster prepayments mean the PO investor gets their money back sooner, which can dramatically increase their return.
The value of a PO Strip is incredibly sensitive to changes in interest rates, as this directly influences homeowner behavior. Unlike a stock, whose value is tied to a company's performance, a PO's value is a pure play on interest rate movements and the resulting prepayment speed.
The relationship is quite straightforward:
While less dramatic than interest rate swings, the creditworthiness of the underlying borrowers matters. If a large number of homeowners default on their mortgages, the expected principal payments will never arrive, resulting in a direct loss for the PO investor.
For the typical value investor, PO Strips are more of a cautionary tale than a viable investment opportunity. While the concept of buying something for 50 cents that will one day be worth a dollar sounds appealing, the reality is far more complex and speculative.