A tranche, in a securitized structure, that receives only the interest payments on the underlying collateral (e.g., MBS, MBO, etc.)
The sum of all interest payments depends on the timing of repayment on the other component of the structure: principal repayment on the principal only tranche. If interest rates drop, the principal repayment will get accelerated (early repayment becomes the norm)- a situation reflecting the so-called contraction risk. Premature repayment of the principal, associated with decreases in the applicable discount rate, implies that the principal only portion will appreciate in value. On the interest side, faster prepayments reflect less interest payment over the term of the structure, which means the interest only (IO) tranche will experience depreciation in value.
In the opposite scenario, an increase in interest rates will lead to slower prepayments- a case of the so-called extension risk. As interest rate increases (discount rate is also driven up), the PO portion loses value. As more interest payments come in, the IO tranche gains more value.
The market value of this tranche (IO tranche) and the PO tranche, in the structure, must be equivalent to the market value of the securitized instrument/ structure.
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