By Daniel Castro, director, with contributions by Theresa O'Neill, Alexander Batchvarov, Joseph Shatz, vice presidents; Ganesh Rajendra, assistant vice president; and Gerald Lucas, director, Merrill Lynch ABS Group
What is important?
Liquidity is a concern for all market players. Dealer inventories are running as light as they have been since the early days of the asset-backed securities market. We expect that situation to persist into the foreseeable future, which means that market liquidity should remain permanently weaker going forward.
Both issuers and investors are concerned about liquidity during the fourth quarter. Even if the primary computer issues associated with Y2K do not ultimately create significant problems, the secondary considerations created by the behavior of market participants are already influencing supply/demand technicals and will likely continue to do so until the first quarter of next year.
For the moment, many investors are willing to pay up for the highest credit quality, most liquid names in the ABS market. As a result, spread tiering, based on liquidity and credit quality will continue to manifest itself.
What Do We Think?
As we have indicated since early this year, supply for the second half of 1999 will largely be compressed into the next three to four months. Clearly, the pace of supply will put pressure on ABS spreads, and they probably will move gradually to wider levels. Our view is that investors should not be shortsighted. Most of the top issuers in the ABS market plan to be active during the next two months.
Investors looking for the best quality/liquidity combination are most likely to find it before spreads hit their absolute wides for this calendar year. Although we do agree with those investors who believe spreads will be at their widest during September and October, we are of the opinion that a significant portion of the bonds available during that time frame may not be suitable for many investors. It is our belief that whatever short term widening may occur over the next three to four months, it will be retraced to tighter levels in January 2000.
Our investment recommendations are little changed from last month. We believe that each investor must balance his or her need for liquidity against their desire for yield. The best liquidity in the ABS market will continue to be found in the top credit card issuers, both fixed and floating rate, in maturities between three and five years, along with prime automobile ABS from tranched owner trust structures.
We believe the best compensation in the ABS market can still be found, however, in the less liquid out-of-favor sectors of the market. As a result, we still strongly recommend single-A and Baa/BBB rated subordinated tranches (selectively) from top issuers. We also continue to like investments in non-prime automobile, retail credit cards, equipment, and utility rate reduction/stranded assets ABS.
Total Return
During June, spreads in most fixed rate ABS sectors ended the month wider. As such, the fixed rate sector underperformed Treasuries by about 65 basis points. During June, most of the fixed-rate indexes had negative total returns, while most of the floating-rate indices had positive total returns. On an absolute basis, the fixed rate sector underperformed the floating rate sector (-31 bps for the fixed rate sector versus +36 bps for the floating rate sector).
Within the fixed rate sector, auto ABS had the best absolute total return. Within the floating rate sector, home equity ABS had the best performance on an absolute basis. Similar to the fixed-rate ABS sector's June's performance, the corporate master index underperformed Treasuries.
For a narrower comparison, both the finance and bank indexes underperformed Treasurys but outperformed the ABS sector. On a total return basis, ABS investors who overweighted the floating-rate sectors performed best.
As discussed in the spread section, spreads, hence performance, was negatively impacted by expectations of heavy supply and weakness in other fixed income markets.
For the full year, we expect total return and price performance to be positive. We believe the sectors with the best performance potential over the year are real estate related and, on a selective basis, the non-triple-A markets.
Recommendations
Heavy third quarter supply should maintain a generally steady bias toward slightly wider spreads over the next three months. However, we do not believe the total magnitude of this widening will be that substantial, since quite a bit has already been priced into the market over the past two months. We believe that investors should continue to overweight ABS, which generally widened more than other sectors in the past month. New ABS purchases are more likely than not to see some widening over the next three months, but we believe these spreads will be retraced to tighter levels early next year.
We continue to see value in subordinated tranches. We also continue to believe that investors are well compensated in the non-prime automobile and retail credit card ABS sectors. Both of these sectors have very good collateral performance relative to credit enhancement levels, and have a generous spread pickup in relation to prime auto and bank credit card paper.
We have also increased our weighting to utility stranded asset/rate reduction bonds, since they are currently trading anywhere from four to eight basis points behind comparable average life credit card ABS.
This article is an excerpt from The ABStract.
