For investors anticipating the Federal Reserve's tightening cycle to end soon, Barclays Capital analysts suggest PAC-II inverse IOs. Specifically, with risks of an increase in prepayment speeds, they prefer inverse-IOs off of a PAC-II tranche. They believe the trade will allow investors to pick up yield, OAS and return, and, at the same time, be protected from a brief rally in rates that leads to slightly faster - albeit temporary - prepayment speeds.

As an example, they examined FHR 3041 SE. The bond is an inverse IO off a PAC-II tranche backed by 6.0% 30-year collateral. The coupon is 6.75 minus one-month Libor. The yield is 24.8% and OAS is 454 basis points. The underlying collateral has a current prepayment history of 17.4 and 20.8 CPR for one- and six-month speeds, respectively. At these respective speeds, the bond has a yield of 15.5% and 17%, calculate analysts. The yield is negative at its life speed of 24 CPR.

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