With the significant jump in IO production in the CMO market, investors should be prepared as supply is expected to exceed $15 billion in 5.5% IO equivalents, said a recent report by Lehman Brothers. Other analysts also talked about the decoupling in performance between the structured IO sector and the trust IO market.
Dealers are being forced to use premium collateral as deal coupons, creating a supply and demand imbalance in the structured IO sector, analysts said. Art Frank, head of mortgage research at Nomura Securities International, said that with the 10-year Treasury yielding 3.36 (as of Thursday afternoon) and the Mortgage Bankers Association (MBA) Refinancing Index above 8,000, there is not much demand for structured IOs. However, at the same time, there has been a deluge of structured IOs because par priced tranches of premium collateral cannot be created without creating IOs. Many asset-liability managers want to buy these tranches at or near par, and IOs need to be created to bring the bond coupons down, below that of the collateral coupons.
In the report, Lehman Brothers notes that this situation will only worsen, as it will take some time before there is enough float in the lower coupons. Meantime, bank demand will remain robust and CMO issuance will likely increase from current levels. The report said that the net upshot of this is a significant increase in the supply of structured IOs. Compared with roughly $8 billion 5.5% IO equivalents in March, Lehman predicts structured IO supply to exceed $15 billion by July. The firm suggests for investors to be very cautious around lower coupon IO exposure.
Meanwhile, JPMorgan Securities said, in a report released last Wednesday, that there appears to be a complete decoupling between the trust IO and structured IO markets. JPMorgan said that the trust IO market has held firm, despite the unprecedented level of the Refinancing Index. On the other hand, the structured IO market has performed poorly
The firm added that many market players are still drawn to "single digit" prices - ignoring historically tight price multiples. There was also some servicer PO selling last Wednesday, which further tightened IOs, said JPMorgan, "In our view," wrote analysts, " single digit prices' are no protection as price downside remains (and in percent terms it is substantial) combined with a slow death through negative carry with difficult to monetize convexity."
Nomura's Frank said that there is value in the higher coupon trust IOs. IOs of higher coupon collateral are essentially out of the money puts on the bond market. This means 6s and higher are already priced to prepay as fast as they are going to prepay and they are currently fully refinanceable. So if rates drop another 25 basis points, it really does not make them any more refinanceable. On the other hand, if rates go up 50 basis points, these premium coupons would slow down quite significantly, particularly for 6s. In this sense, it is not necessarily a bad thing to pay up 8.5 to 9 points for a 6% option IO, where the prices would rise if rates increase 50 basis points and would not change much if rates drop 25 basis points. However, Frank stated that 5.5% IOs are still very sensitive to rate movements.
"I think that some of the more attractive bonds are the 6s," said Frank. "The prices can rise if rates increase but they are already priced to super fast speeds so they would not really decline much if rates dip."
