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A Weekly FaxLetter
LEVERAGING WITH INVERSE-IOS
January 11, 1994

Summary: Inverse IOs (IIOs) are highly leveraged instruments and

typically provide attractive current yields. However, the
The structure of Inverse IOs (IIOs) is implicit leverage and characteristics of the underlying bond
evaluated relative to the underlying bond should be evaluated prior to the purchase of these bonds.
and the floater tranche. IIOs can be This commentary considers the components of IIOs and
discusses a general framework for analyzing these bonds.
viewed as leveraged investments in high
premium CMOs financed at a spread to Structure
LIBOR. Based on the IIO price, both the IIOs are generally carved out from high premium CMOs.
implied spread on the underlying bond The underlying premium CMO bond can be of any type
and the implied financing rate can be (i.e. PAC, sequential, support, etc). From the given CMO
derived. These measures can be used to bond, a floater tranche is created with a cap to ensure that
assess the value of IIOs. Additionally, there is always enough coupon from the underlying bond to
investors are advised to evaluate the pay the floater. The face amount of the floater can vary
from being equal to the face of the underlying to being
effective duration of the IIO and perform
slightly less. The remaining IO and principal, if any, constitute
sensitivity analysis to various prepayment the IIO tranche. If the floater balance is equal to the balance
and LIBOR vectors. of the underlying bond, the IIO simply receives the interest
differential between the two. In this type of structure, the
IIO is referred to as a notional IIO. If there is a small principal

Quantitative Analysis MARKET SPREAD TO OPTIONS ANALYSIS RISK PREPAYMENT

Jan Settlement
01/07/1994 WAL Zero Fwrd Option Fwd Curve Base FWD Base FWD

Agency Mat CPN WAM AGE Price Yield TRSY Curve Curve OAS Cost Effect Dur Convex PSA PSA WAL WAL

FNMA 30 6.0 358 2 97 - 12 6.44 79 80 64 57 7 16 6.6 -0.4 127 95 10.1 11.6

FNMA 30 6.5 358 2 100 - 6 6.50 116 104 78 61 17 26 5.8 -1.2 187 106 8 11.1

FNMA 30 7.0 356 4 102 - 14 6.44 139 126 99 68 31 27 4.7 -2.0 303 131 5.5 9.9

FNMA 30 7.5 354 6 104 - 4 6.20 156 122 121 73 48 1 3.4 -2.2 446 192 3.9 7.7

FNMA 30 8.0 352 8 105 - 8 5.91 156 99 127 75 52 -28 2.3 -1.7 581 312 2.9 5.2

FNMA 30 8.5 348 12 105 - 24 5.69 152 80 119 76 43 -39 1.5 -0.8 676 444 2.4 3.6

FNMA 30 9.0 324 36 106 - 24 5.52 139 64 102 71 31 -38 1.6 -0.2 594 461 2.3 3

FNMA 30 9.5 300 60 108 - 18 5.29 112 42 73 54 19 -31 1.6 0.1 572 488 2.4 2.8

Based on Michael Herskovitz, Inc. and Andrew Davidson & Co., Inc. OAS model and prepayment model
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Table 1. Characteristics of FN92-177 SB and FB

Bond Type Face Coupon (%) Cap Floor PSA Avg Life
SB IIO 324,854 -124 x L + 1165.6 1165.6 0 600 1.68
FB Floater 40,281,896 L + .60 10 .6 600 1.68
Underlying Sequential 40,606,750 9.92 9.92 9.92 600 1.68
(Bond U)

balance on the IIO (generally a very small percentage of points. Based on the IIO price, the price on Bond U is cal-
underlying bond such as 1/100th), it receives the principal culated by:
payments pro-rata in addition to the IO component. In
Bond U Price = IIO Price x 1/(Leverage) +
either case, there is a high degree of leverage and the IIO
Floater Price x (1-1/Leverage)
can be viewed as an investment in the underlying bond
with a large percentage of it financed at a spread to = 1225 x (1/125) + 100 x (1 - 1/125)
LIBOR. = 109,

Example: FN92-177 SB where Leverage = 1+ LIBOR Multiplier.

The characteristics of the SB tranche, its corresponding After deriving the price of Bond U, the yield and spread
floater tranche and the underlying bond (Bond U) are given can be calculated (on the Bloomberg, bring up Floater
in Table 1. The deal is backed by FN 7.5 with WAC = tranche and set the LIBOR index such that the coupon is at
8.04% and WAM = 339 months. The face of the Bond U the fixed rate of Bond U; in our example,the index = 9.32,
is the sum of the two component bonds while the underly- coupon=9.92). The yield calculations are based on a pre-
ing coupon is calculated as the individual coupons weighted payment assumption of 600 PSA, giving the bond an average
by their corresponding face amounts. The coupon of Bond life of 1.68 years.
U is higher than the collateral because it receives some IO
Table 2. Implied Spread Analysis (Floater = 100)
strip from tranche B, a discount sequential bond which
pays pro-rata with the floater and IIO tranches. IIO Bond U Implied Implied
The coupon of the IIO has a leverage of 124 versus LIBOR Price Price Yield Spread to 1-2
and its face is 1/125 th of Bond U. The IIO can thus be
yr Split
viewed as a purchase of the Bond U with a large percentage
of it being financed at LIBOR + 60 basis points. 1225 109 4.32 +52
Additionally, the financing rate has a cap of 10%. 1125 108.2 4.80 +100

Implied Spread and Implied Financing 1025 107.4 5.29 +149

Given a price on the IIO, its value can be assessed by com-
If the IIO is purchased at a price of 1225, it is equivalent to
puting either the implied bond spread or financing. With a
investing in Bond U (face equal to 125 times that of IIO) at
pricing assumption on the floater, the implied spread on the
a spread of 52 basis points over Treasuries and obtaining
underlying bond can be calculated. With a pricing on the
financing at LIBOR+60 with a 10% cap.
underlying bond, the implied financing rate can be calculated.
Table 2 shows the implied spreads for different prices on A similar analysis can be performed where the implied
the IIO assuming a 100 price on the floater bond. At a financing is derived, given an assumed price on the underlying
price of 100, the floater has a discount margin of 60 basis bond. Let us assume that the Bond U is valued at 107.4.
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The implied financing rates are shown for different IIO Furthermore, the duration drift can be significant with
prices in Table 3. changes in prepayments and rate levels.
Table 3. Implied Financing Analysis (Underlying = 107.4) Bonds backed by seasoned high premium collateral should
IIO Price Floater Price Implied Financing exhibit a better convexity profile than cusp or current
coupon collateral. The convexity profile of the underlying
1225 98.39 L+160 bond should be evaluated to assess the overall convexity of
1125 99.19 L+110 the IIO.

1025 100 L+60

Risk Components
The primary factors affecting the performance of IIOs are
prepayments and the changes in both short and long term
rates. A curve steepening accompanied by slower prepay-
ments is favorable to IIOs while a flattening with faster pre-
payments hurts their performance. Since IIOs are generally
backed by high premium tranches, the effective duration of
the underlying bond is relatively short. Due to the leverage
factor, however, the effective duration of the IIO can vary
greatly from a flat duration to a very long duration.
Summary and Recommendations
IIOs provide a mechanism for leveraging investments in
high premium CMO bonds without entering into repurchase
agreements or other types of financing. Due to the high
leverage factor, however, IIOs generally exhibit a high
degree of sensitivity to both prepayments and LIBOR rates.
Investors are advised to evaluate the implied bond spread
levels or the implied financing rates in the context of the
financial institution’s funding costs and perform sensitivity
analysis to various prepayment vectors and LIBOR rates.

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