and decrease as interest rates decrease (i.e. negative duration). If mortgage prepayments increase, or the market's expectations of future prepayments increases (i.e. higher expected PSA speed), the expected aggregate dollar amount of interest payments [and therefore the market price of the IO tranche] would generally be expected to decrease. By contrast, if mortgage prepayments decrease, or the market's expectations of future prepayments decreases (i.e. lower expected PSA speed), the expected dollar amount of interest payments [and therefore the market price of the IO tranche] would generally be expected to increase. Therefore, IOs have investor demand due to their expected negative effective duration as they can be used as a hedge against conventional fixed-income securities in a portfolio. Additionally, since investors are only buying a portion of the overall cash flows and are not entitled to any payments of principal (the PO tranche), the cost of the IO trance may be significantly lower than that of the PO tranche. While IO and PO tranches have different risk characteristics, neither the IO nor the PO represents a leveraged position in the underlying collateral pool. Principal only (PO) A principal only (PO) strip may be carved from collateral securities to receive just the principal portion of a payment. Since the IO tranche has negative duration, a PO typically has more effective duration than its collateral. One may think of this in two ways: 1. The increased effective duration must balance the matching IO's negative effective duration to equal the collateral's effective duration, or 2. Bonds with lower coupons usually have higher effective durations, and a PO has no [zero] coupon. POs have investor demand as hedges against IO-type streams (e.g. mortgage servicing rights). See also References Footnotes Works cited Structured finance Mortgage Fixed-income securities Mortgage-backed security