Because of the weight of CMO supply, IOs have become cheaper, a topic hitting bank research last week.

UBS Warburg researchers argued that the biggest development during the past few weeks has been IO devastation - the sector has gone from quite rich to somewhat cheap. With the CMO market throwing off a significant amount of structured IO product over the last month, this has resulted in a glut of IO-type cash flows. Analysts said that the demand for cash flows was weakened because of the higher-than-expected March prepayments and a very high Mortgage Bankers Association (MBA) Refinancing Index on March 12.

"This has resulted in a dramatic realignment in the IO market," wrote UBS researchers. IO cashflows have not only become somewhat cheap, synthetic premium trades using current coupons and IO also appear attractive compared to premium passthroughs. Though technicals may remain negative, this will likely reverse itself within the coming weeks.

Meanwhile, last Wednesday researchers from Merrill Lynch asked why IOs have done so poorly. They said that one reason is that IOs were rich even at the start of the year. As the market rallied, dealers creating CMOs also found it necessary to strip down coupons, something that has created a considerable supply of structured IO cash flows. Added to this, dealers began doing stripped down deals off Trusts themselves, which actually generated more demand for PO and IO supply. Also, usually when a sector drops as quickly as IOs have recently, there may be some technical factors that have come into play.

Merrill concluded that IO cash flow is currently on the cheaper side, and some structures may even be cheaper than the generic trust market.

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