Investors are facing both increased extension and call risk at the moment. For these buyers, Barclays Capital suggested stripped down 10/20 IOs because they allow the creation of lower priced bonds, which helps fight premium erosion. Meanwhile, the higher WAC protects against extension risk.
Additionally, 10/20 IO collateral has exhibited call protection as the underlying borrowers are sensitive to their monthly payments and extension protection through increased delinquency buyouts.
In a further examination of prepayment behavior, the Barclays' report noted that across rate incentives, 10/20 IO borrowers are prepaying about 5-10 CPR slower than their conventional counterparts.
The current environment lacks "affordability" choices for these borrowers, with the only choice being fully amortizing 30-year mortgages if borrowers want to refinance. As this option results in a higher monthly payment with the inclusion of principal in the payment, speeds tend to be slower despite the historical low rate levels as borrowers choose not to refinance.
On the extension side, 10/20 IOs and other affordability mortgage products have higher delinquency risks and so higher buyout potential which should keep prepayments strong even as mortgage rate back up.
In their report, Barclays analysts recommend 4.5/6 IO and 4.5/6.5 IO as "excellent shorter average life bonds that pick up spread to FNCL 4.5s while also significantly reducing the risk of extension if rates sell off and voluntary prepayment speeds slow down."