Amherst Securities Group (ASG) analysts reviewed three categories of 5/1 hybrids with different interest-only terms, including non-IO, five-year IO term and 10-year IO term in a report released this afternoon.

The article, ASG analysts said, was prompted by some investors ignoring differences among
hybrids with different IO terms. Others, on the other hand, will not even look at bonds that are backed by a considerable amount of 10-year IOs.

Neither investment approach is reasonable, according to analysts. They suggested that investors examine the effect of the different hybrid types' behavior and its impact of valuation.

This was an attempt on the analysts' part to evaluate the performance impact caused by payment shock as well as the resulting effect on value.

Analysts set up various scenarios to show the transition and prepayment behavior of these categories.

The analysis showed that even though the payment shock on 10-year IOs is very large, the overall effect on collateral liquidations, tranche write-downs and valuations is comparatively slight, they said.

The much lower transition rate on the 10-year IOs and some prepayments before IO expiration lessens the the payment shock effect.

However, pay shock for the 10-year IOs at 121 months from origination will be very considerable, analysts stated.

Transition and Prepay Rates

This analysis also demonstrated that transition rates are determined mostly by pay shocks. Meanwhile, prepayment rates are more sensitive to refinancing incentive.

Analysts projected the pay shock and the refinancing incentive, and their impact on performance for each of these IO types.

This analysis showed that the valuation effect of the 10-year IOs is relatively modest. That is, for the first five years post reset, the transition rates on these instruments are so much lower that even with considerable pay shock after 10-year IO term reset, the total collateral liquidation rates
are not that much more. Thus they do not significantly affect valuation.

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