Lehman Brothers is recommending the hybrid IO sector as a place of opportunity for relative-value players, in a newly issued report.

Valuations make these IOs attractive substitutes for trust counterparts even with stressed prepay assumptions, analysts said.

Lehman stated that, at current valuations, hybrid IOs look undervalued relative to their trust counterparts.

Additionally, there is sufficient cushion in current multiples to have any potential deviation from model prepayment assumptions. The sector also provides an attractive hedge for portfolios against a potential slowdown in turnover.

Lehman said that from the standpoint of valuation, hybrid IOs are different from trust IOs in three ways. The first difference is that hybrid IOs usually have a maturity like the fixed-leg (five-years in a 5/1, for instance) versus the 30-years in trust IOs. The next reason is prepayments, specifically turnover, on hybrid ARMs are faster compared to fixed-rates due to a self-selection of shorter horizon borrowers moving into the product. Lastly, researchers said hybrid IOs are usually net WAC IOs while trust IOs have a fixed coupon.

Lehman concluded that hybrid IOs look attractively valued relative to their trust counterparts. In terms of the IO multiples implied by the agency 5/1 sector, model valuations of 5/1 hybrid IOs appear reasonable. The valuations of hybrid IOs are not as sensitive to turnover /refinancing assumptions compared to trust IOs. This is why even while there is somewhat more uncertainty regarding turnover, these IOs still serve as attractive substitutes for their trust counterparts.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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