Principal-Only Strip (PO)

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:

• Regular monthly amortization, where a small part of each mortgage payment goes towards chipping away at the loan balance.
• Loan prepayments, which are the main event for a PO investor. A prepayment occurs when a homeowner pays off their mortgage early, usually by selling their house or refinancing their loan.

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:

• Falling Interest Rates: This is the best-case scenario for a PO investor. When market interest rates fall, homeowners rush to refinance their mortgages to lock in a lower payment. This causes a wave of prepayments, meaning the PO investor gets their discounted principal back much faster than anticipated. Getting your money back sooner is always better due to the time value of money, so this accelerates and increases the investor's effective yield.
• Rising Interest Rates: This is the PO investor's nightmare. As rates climb, homeowners have zero incentive to refinance; in fact, they will cling to their old, lower-rate mortgages for as long as possible. Prepayments slow to a crawl. The investor must now wait much longer to receive their principal, which crushes their annualized return. This is a classic example of extension risk.

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.

• Speculative Instruments: POs are not investments in a productive business; they are derivative bets on the direction of interest rates and the unpredictable behavior of homeowners. Their value can swing wildly based on macroeconomic news.
• The Opposite of Predictability: Value investing is built on the principle of analyzing businesses with durable competitive advantages that produce predictable cash flows. The cash flows from a PO are notoriously unpredictable, making any fundamental valuation closer to a sophisticated guess than a reasoned analysis. There is virtually no margin of safety.
• A Tool for Traders, Not Investors: In essence, POs are tools for institutional traders and hedge funds to hedge interest rate risk or make highly leveraged bets. For the ordinary investor focused on building long-term wealth by owning great companies, POs represent a level of complexity and risk that is best observed from a safe distance. They are a fascinating piece of financial engineering, but a poor fit for a value-oriented portfolio.