These mortgage backed securities can be divided into tow main groups. Here are some definitions you never want to bother with. All such securities are created by stripping the coupon interest from the underlying mortgage to create the PO and the associated interest only IO security. PO's are sold at a deep discount to face value. Because there is no coupon, the financial performance of the PO is extremely sensitive to prepayment rates.
Higher prepayments leads to a more rapid return of principal and higher return.
In their pure form, IO's are sold at a deep discount to their notional principal amount. The notional amount is the principal balance used as a reference to calculate the amount of interest due. IO performance is highly sensitive to prepayments rates, but IO's increase in value when prepayments rates decline. This feature gives IO's some of the characteristics of hedging instruments with negative duration. Tranche is French word for slice.