PHOENIX - As an increasing number of investors are expected to pour into the still-green ABX.HE index, liquidity once focused on a wider array of issuer deals could begin to dry up on the single-name ABS credit default swap front, at least in the near term, according to participants at this year's ABS West conference here last week.
If the trend sticks, CDO managers could have a difficult time finding enough liquidity in the single-name ABS swap market to fill synthetic allocations within their deals.
"The index sucked liquidity out of the rest of the market," said Sean Rice, a managing director at Bank of America Corp.
The ABX.HE index, unveiled last month, consists of five indices referencing baskets of subprime RMBS reference obligations ranging from triple-A to triple-B minus. The indices reference a basket of RMBS pools from 20 issuers, with a minimum deal size of $500 million, among other criteria. For now, reference entities on the index only consist of new-issue deals, and only the initial 20 names. As the index rolls every six months, the possibility arises for new issuer names and additional vintages to become available to reference. Hedge funds and broker-dealers are heavily involved in the market, but an increasing number of general investors are expected to be drawn to the index.
Because increased interest in the indices took business away from the single-name ABS CDS market, the 20 issuer names that currently make up the index became easier for investors to express an interest in while liquidity for other issuers became more difficult to come by.
"Names that were in the index became pretty easy to short, but managers wishing to go outside of the index to fill synthetic buckets will be faced with a challenge," Rice said.
The concept of incorporating the indices into CDO collateral has been met with skepticism in the investment community. Investors reason that CDO asset managers are charged with picking the best collateral, and that it would be lazy to simply reference the index. Rating agencies have confirmed that they have received inquiries into doing just that. Industry participants anticipate the ABX.HE index will be incorporated into CDO deals as the market matures and structures evolve.
In the meantime, "[managers] will have to work a little bit harder to find names, and find differentiation from other managers in the market," said Stan Stratton, a director at Merrill Lynch. "It is going to be incumbent upon the manager[s] to show that they can actually go out there and pick the names, and that they can source it."
One area expected to be a boon to refreshing liquidity across the single-name market is the development of ABX.HE-linked tranche issuance.
"It's important to get the tranche market off the ground because it will cause a need for hedging of non-index names, creating more liquidity," Rice said.
The biggest challenge toward tranching the ABX.HE index, however, is the absence of maturity in the sector, and the lack of the cheapest-to-deliver strategy - delivering the least expensive underlying asset to satisfy CDS contract requirements - employed within the corporate synthetic market, Rice said. He's seen quasisingle tranches of the index, but expects full-out tranche trades to occur by midyear.
"It is probably a matter of months before you see that market begin to develop," Rice said.
Stratton added, "I think next year single tranches off the ABX index will be old news."
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