STRIPS is the acronym for Separate Trading of Registered Interest and Principal of Securities. STRIPS let investors hold and trade the individual interest and principal components (also known as stripping) of eligible Treasury notes and bonds as separate securities.
The origin of Strip Bonds can be traced to the 1960s, when Investment Dealers in the United States began (physically) clipping coupons from bearer government bonds and selling the individual pieces as separate securities. These clipped bonds gained immense popularity and their sales gained momentum in the early and mid 1980s as the interest rates surged to high levels. This was so because it allowed investors to lock in the very high yields that were available at that time, without worrying about the risk of not being able to re-invest future interest payments at the same high rates.
The interest and principal steam of cash flow are deterministic and are known in advance. These are sold at their present values as deep discount bonds. The principal only (PO) and interest only (IO) segments represent two synthetic instruments that are excellent hedging instruments. By investing in various combinations, investors can create their own risk-return profile, something not enabled by holding plain-vanilla puts. The strip reacts differently to changes in interest rate behavior. The price movements of strips are impacted the repayment effect, discounting effect and their combined effect.
In the case of principal only (PO), a fall in market interest rates would induce mortgage borrowers to prepay existing loans and borrow a fresh at lower rates. This will accelerate the cash flows appearing in the numerator, and reduce the discounting factor in the denominator; both effect together leading to a value appreciation and hence price of a PO. Reserve is the case for a rise in the interest rates where borrowers would stay put and tend to prepay, and the denominator rising, leading to a fall in the price of a PO.
In the case of the interest only (IO), a fall in the markets interest rates would reduce the denominator to lift the price. However, due to repayment, large section of outstanding would be bereft of future interest inflows. This represent losses in the interest income to service the IO. The magnitude of interest rates shift and prepayments would determine the combined effect and final value of the IO. A rise in the interest rates would protect the numerator, but there will also be a rise in the denominator. Here again, the combined effect and the impact on the final valuation depends on the magnitudes of the rate shift.
Hedging instruments, bank investing in the long end of the market would like interest rates to be high. They therefore would buy POs to protect their losses. Bank wanting interest rates to fall to increase their lending volumes would be interested in getting hedge protection by investing in Ions. Thus, it is to be understood that PO and IO strip moves in opposite directions in relation to interest rates shift in order to devise hedging strategies.