The unusually narrow gap between unsecured corporate and ABS spreads has Salomon Smith Barney researchers Peter DiMartino and Mary Kane noticing a unique profit-making play - exploiting the disproportionate correlation in spread movements for ABS versus corporate debt.
In a research piece entitled "Mind The Gap - Between Secured and Unsecured," Salomon notes the "little spread difference between the two markets," as well as a belief that these narrow differentials will soon reverse course. Because of this, the firm recommends the use of credit default swaps in lieu of shorting the unsecured debt in the cash market.
"Triple-B credit card spreads have tightened considerably in the past few days, owing to ABS tightening." DiMartino notes. "However, we believe triple-B ABS can tighten further to the unsecured market." This is because volatility is much higher in triple-B credit on the unsecured side: "Triple-B corporate name selection can be fraught with peril," Salomon says.
Purchasing the option allows an investor to sell an unsecured bond of a particular credit at par at any time up to one year. Then, assuming the unsecured bonds sell off - widening as well as moving below par - the option gains value.
Salomon thinks that the Enron fallout may soon be pushing investors out of corporate debt, and that some of these investors will find triple-B ABS a safe haven. "Acute Enronitis," as DiMartino calls it, "may have begun to infect investor sentiment."
The bank also notes that the ABS market will begin benefiting from the new bank capital regime, where FDIC-regulated institutions are now allowed to hold more ABS versus the capital held (though triple-B securities are still 100% risk-weighted, Salomon notes).
Salomon uses the example of buying triple-B cards while purchasing credit protection on the triple-B corporate name. "The value in this trade is that the asset-backeds typically widen in smaller increments as their unsecured corporate counterparts move out," said Kane. Derivative spreads, on the other hand, generally move point-for-point with the reference obligation.
With this trade on five-year MBNA paper, for example, the investor buys protection for 160 basis points, the assumption being that triple-B ABS widens only 10 basis points for every 50 basis points on the corresponding corporate securities. Because they widen disproportionately to each other, the loss on the widened cards is covered by the gain on the credit default swap (as the derivative is essentially an option to sell the bonds at par to the protection seller within one year's time).
"This is a spread trade," comments DiMartino of the idea. "The strategy is that we believe asset-backeds will tighten more than unsecured at this point. We believe ABS is a bargain, relative to the unsecured markett."
"The investor will profit from the spread-differential widening when the credit derivative widens or the ABS narrows more than the derivative," says the Salomon research.