Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques

COUPON STRIPPING AND BOOSTING

One of the common structuring techniques is reducing or “stripping” the coupon of a bond or series of bonds to make such securities more appealing to investors that seek par or discount-priced securities. As noted in the discussion on time tranching on floater/inverse structuring, fixed rate collateral pools and parent bonds in the mortgage-backed securities (MBS) universe have fixed dollar amounts of interest associated with them. Changing the coupon of a bond within a prime MBS structure, therefore, is a process of reallocating interest within the structure. As such, stripping the bond coupon creates interest cash flows that must be either directed elsewhere in the structure or sold as IO securities or tranches.²⁰

The simplest form of coupon stripping is to split the parent bond into two tranches. Interest taken from one bond (the “discount,” in this case) is allocated to the other bond (the “premium”), creating a “parallel split.” As a simple example, a $10 million face value tranche with a 5.5% coupon can be split into $5 million of bonds with a 5.0% coupon and $5 million of a 6.0% coupon bond. This split suggests that there is greater demand for both the 5.0% and 6.0% coupon bonds (the “children”) than the original 5.5% parent tranche.

IOs can be created at a number of different levels within the deal. The entire collateral pool can be stripped. For example, Fannie Mae 6.0s can be stripped into 5.5s by creating an IO tranche, which will ...