What is the characteristic of Interest-only (IO) tranches?

Interest-only (IO) tranches are a specific type of security that primarily pay interest to investors. The characteristic of these tranches is that interest payments decrease as the principal is paid down. This means that as borrowers make principal repayments on the underlying loans, the amount of interest that is paid to IO tranche holders declines. This occurs because the interest payments are calculated based on the remaining principal balance of the loans; as the principal decreases, the interest payments also decrease.

This feature makes IO tranches particularly sensitive to prepayment risk – if the underlying loans are refinanced or paid off earlier than expected, the principal paydowns happen sooner, leading to reduced interest payments for the IO tranche holders. Understanding this characteristic is crucial for assessing the cash flow dynamics and risk profile associated with these instruments.