As ABS spreads approach their underlying benchmarks, and value becomes increasingly scarce, sell-side researchers have diverging views on relative value, and what strategy investors should employ. For the first time since mid-2002, some banks have begun recommending a neutral stance and many prefer off-the-run names and sectors.
Last week Lehman Brothers shifted its bias for ABS to neutral from overweight, as spreads have tightened to the point of being overvalued, the firm said. Despite what it calls "powerful demand technicals" in the ABS market, Lehman believes that ABS spreads "are close to a spread floor," and sees little upside in the current market, with a couple notable exceptions.
In the most recent weekly commentary, Lehman researcher David Heike notes that fixed-rate prime auto and stranded cost ABS are trading in the low single digits over comparable swaps. Floating-rate credit cards are trading flat to Libor at the front end of the curve. Home equity ABS is at all-time tight spreads.
Lehman's Heike concedes that current strong demand will likely keep spreads tight in the near term. "For most assets, the narrow spreads and flat curve provide little protection against any potential interest rate, credit or headline risk that may arise in the future," Heike said.
"We still like off-the-run names and sectors," added Heike. "We recommend investors sell liquidity for yield and take on credit risk," He added.
Deutsche Bank Securities is also recommending a similar change in investment strategy. "Spreads feel softer as the euphoric bid has been dampened slightly by the historically tight spreads and volatility in corporates and equities," the firm notes in research.
"Any time spreads reach cyclical tight levels, like where they are now, it's time to take profits," Deutsche Bank's Anthony Thompson said. "For total return investors, its hard to recommend ABS." He added, however, that in the event of a credit shock - which he views as unlikely - ABS will widen less than other fixed-income sectors.
Lehman's Heike also said he views a market-wide credit event as being unlikely.
That said, Deutsche Bank likens the current credit environment to a previously experienced pre-crisis stage. "With credit spreads moving so quickly to tighter levels, we have to wonder how and where will fixed- income investors try to outperform," notes Deutsche Bank in its monthly research. "We can't ignore the fact that it was a similar situation such as this one that preceded the Long-Term Capital Crisis.
As for where investors should put their money to work, most recommend subordinates and off-the-run sectors. Lehman cites single-A rated home equity floaters, trading 30 basis points cheap to its historical tight level, as having value. Other floaters in the capital structure are fully valued, he adds.
Where to look?
"When doing a cross-sector analysis verses corporates, ABS spreads still offer [yield] pickup," one portfolio manager said. "We looked at a recent long dated RRB bond at swaps plus high teens the other day. It was an up-in-credit trade - triple-A compared to single- and double-A corporates - and offered 10 bps in incremental yield. ABS still makes a nice proxy trade, even in this environment."
Fixed-rate home equities, meanwhile, are fully valued, according to Lehman. Furthermore, should prepayments slow by as little as 10% CPR, Lehman sees five-year fixed-rate home equity classes extending by as much as two years.
Amid the brouhaha over the manufactured sector lately, now may be the time to cash in some returns and reduce exposure to the sector. "We remain constructive on MH spreads given the improving collateral trends and continued positive macro developments, although we advocate a lower overweight following the strong rally over the past couple of months," Lehman argues.
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