Vanderbilt Capital Advisors
SYNTHETIC SECURITY COMBINATION
Investors can create a
synthetic security by using various combinations of interest only (IO) strips and long U.S. Treasury principal strip
issues.
Independently, IOs and
Treasury strips are considered volatile securities. When invested in a combined format their
volatility characteristics are significantly reduced. Creating a synthetic security to achieve a
specific targeted duration can produce meaningful returns under most interest
rate scenarios. The synthetic combination
does not have to influence the duration of the portfolio or interfere with a
portfolio manager's point of view on the yield curve. Analysis reveals that the performance
advantage of the combination appears very favorable across a variety of scenarios.
The combination significantly outperforms six-month LIBOR in unchanged,
parallel shifts, and flattening yield curve environments. The scenario results, very importantly,
assume that the synthetic combination is being actively managed to
maintain the appropriate weighted duration at all times.
The following is a
description that explains IOs and Treasury principal strips and shows how
creating and actively managing a synthetic security can produce desirable risk/return results.
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Description |
IOs are U.S. Government
or agency in quality and represent a form of a mortgage strip. They are created by dividing the principal
and interest from a pool of mortgages and then allocating the interest
component to each IO strip. IOs receive
all of the interest payments from the underlying collateral and none of the
principal. The price movement of IO
strips are quite sensitive to changes in interest rates. Falling interest rates lead to faster
repayments as more people buy or refinance homes. Rising interest rates result in slower
prepayments. Faster prepayments reduce
the principal balance of the underlying collateral leading to smaller interest
payments. Therefore, when interest rates
fall and prepayments accelerate, IO strips decrease in value. When rates rise and prepayments slow, IO
strips increase in value. The owner of an IO earns valuable income and may use
the negative duration of an IO as a hedge against rising interest rates.
U.S. Treasury principal
strips do not earn income but provide a principal payment at maturity. Treasury principal strips increase in value
as interest rates decline and decrease in price when interest rates rise. They are generally used in a portfolio as a
hedge against a decline in rates. In
addition, they can offset the poor price performance of premium mortgage issues
or callable corporates in a rally.