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.

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