The cheapness in five-year fixed-rate home equity ABS has narrowed early this year, sparking debate as to whether any potential extension risk is worth the spread pickup. Since five-year home equities widened to over 90 basis points over Libor in 4Q03, investors have bid spreads into roughly 70 basis points over, but the pickup between the two sectors remains well outside of historical levels.

Peter DiMartino, head of ABS research at RBS Greenwich Capital, recommends five-year HEL paper and has told investors to move into five-year from three-year paper. DiMartino credits the persistent wide spreads to "misguided extension concerns," and he advised investors that "while generic five-year HELs may underperform NAS bonds in a rally, extension risk in a selloff appears to be minor."

At worst, DiMartino sees five-year bonds extending by just one year. "In our view, if fixed-rate home equity prepayment speeds slow appreciably, the five-year likely extends to a six-year bond, [its tenor] is similar to the NAS class. NAS classes appear very rich to us at this," DiMartino said back in January.

Banc One Capital Markets researcher Glenn Schultz agrees, adding that tightening in five-year HELs has lagged the broader rally in ABS spreads, and the sector still has room to tighten. "While most areas of the [ABS] market are at their all-time rich levels, five-year HELs still have 15 basis points to tighten before catching up with the rest of the market," Schultz added.

When the market began noticing the opportunity in this trade back in January, five-year HELs traded roughly 35 basis points cheap to NAS bonds, which have currently moved in to roughly 15 basis points, according to RBS Greenwich's DiMartino.

DiMartino estimates the nominal spread advantage of five-year HELs versus NAS bonds dating back to 2001 has generally ranged from 2 to 15 basis points. Banc One's Schultz, meanwhile, reported a differential as narrow to flat versus NAS bonds as recently as early last summer.

Investors, who have driven five-year spreads in recent weeks, are more concerned with the fundamental aspects of the underlying cashflows than historical spread ranges. "Everyone is reaching for yield in five-year HELs, so spreads are coming in," one investor who favors NAS classes said. "But it is still all about prepays."

Banc One's Schultz stands by his prepayment assumptions, and he suggests that extension-averse investors stay out of fixed-rate HELs altogether. "If you are that fearful of extension, I'd say you should buy floaters in the low 20 [basis point area] over Libor and wait it out," added Schultz.

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