In the definition available here

It seems that both

  1. Interest-only/principal-only securities.
  2. Collateralized Mortgage Obligation Strips.

are types of Stripped Mortgage-Backed Securities (SMBS). However, it seems that somehow the first is also known by mortgage strips. While the second in the same webpage is defined by

One of the classes in a CMO structure can be a principal-only or an interest-only class. These are called CMO strips or structured IOs.

It seems to me that they are both the same or designed for the same purpose. What is the difference between both and why are they considered a different type of SMBS?


To understand the distinction, it is useful to briefly review how Stripped MBSs (SMBSs) were created. We combine a number of pass-through pools to create a Mega pool which then (loosely speaking) issues an SMBS certificate with an IO and PO class. The crucial point here is that the IO and PO class can be combined and exchanged for the underlying pass-throughs based on certain conditions and fees. This feature substantially added to the liquidity of the IO and PO because the MBS pass-through market is one of the most liquid fixed income markets in the world.

On the other hand, an IO (or PO) structured as a CMO class has no such "companion" and consequently is typically much less liquid.

The two markets were created for very different reasons: the IO/PO (SMBS) market allowed you to go long or short prepayment risk in various coupons and could be used to hedge prepayment risk in TBA trades. On the other hand, the IO (or PO) class of a CMO is a byproduct of the structuring process and is usually purchased as a standalone investment; it is not easy to short this class. It is worth noting that is quite rare to see a "pure" IO class in a CMO, the interest-only cash flows are usually further structured to create an Inverse IO etc.

I use the word "were" in the first sentence above because SMBSs have stopped trading for the past several years. The SMBS market was replaced by the IOS market which was, among other things, a little more balance-sheet friendly, but that market too has more or less vanished due to some of the capital constraints introduced by Basel III.

Trading the structured IO classes from a CMO remains fairly active.


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