Last Wednesday, participants in the ABX.HE for the first time ushered in a fresh series of deals with what seemed to be little fanfare. While not everyone shared the same view on credit characteristics underlying the new index, called the ABX.HE 06-2, many felt that market technicals would drive much of the early spread activity. As of last week, a number of sources were expecting ABX.HE 06-2 spreads to settle at a thinner level than those on the initial ABX.HE 06-1 index - particularly at the lower end of the capital structure.
"Because of the HEL spread tightening in the first half of this year, opening coupon prices on the second index will be significantly lower' then the coupons on the first set," RBS Greenwich Capital analysts said last week.
The addition of a second ABX index is expected to bring in a slew of new trading opportunities, including relative value hedges and trading across vintages, according to RBSGC analysts. The most popular slices of the ABX index, the triple-B and triple-B minus tranches, are expected to see the most activity. Hedge funds, which are largely thought of as the biggest ABX investors thus far, are expected to move trades to the new, more liquid index to express both bullish and bearish views. Credit Suisse estimated the new triple-B minus tranche of the on-the-run index could be as much as 50 basis points wider than the newly off-the-run ABX.HE 06-1. Why? Short players, according to Credit Suisse, are less likely to roll, while long players will be enticed to do so.
Comparing credit fundamentals
The on-the-run index is thought-of by most to have similar credit characteristics to the first index. Required credit enhancement levels, for one, are generally the same across the board (taking into account the structure of the deals when they were first issued), according to Credit Suisse, meaning overall deal characteristics are likely similar. Moreover, 18 of the 20 issuers featured in the first index appear again in the second. A Carrington Mortgage and Morgan Stanley deal were added to the mix in the second index, while an Ameriquest and New Century deal were excluded. However, some argue that, unlike the on-the-run index, the ABX.HE 06-1 index enjoys extra time basking in the benefits of home price appreciation. Additionally, many feel as though more recent deals were made under slackened underwriting standards, as lenders have reached for volume in a declining market. On the other hand, the older index is more seasoned, and, as a result, more likely to begin experiencing its first losses.
Taking advantage of differences
Asked RBSGC: "If you agree that the underlying transactions in the ABX.HE 06-1 have better underwriting characteristics, more credit protection, and more built in HPA relative to the ABX.HE 06-2, why should the new on-the-run trade to implied tighter spreads off-the-run?" The investment bank's analysts, along with others, recommend buying protection on the ABX.HE 06-2 triple-B minus index and selling protection on the ABX.HE 06-1 triple B minus index. The trade could bring investors higher levels of credit protection and a positive carry because the coupon of the 06-1 vintage is greater than the coupon from the new vintage, they said. Alternatively, the 06-2 indices, being more liquid, could trade at a premium, RBSGC said.
"It remains to be seen how much liquidity will remain in the off-the-run' 06-1 index," wrote JPMorgan Securities last week. "We believe 06-1 will continue to see fairly robust interest given that the reference obligations on the 06-2 will be completely different from those of 06-1 and 06-1 is six months more seasoned. This differentiation allows investors to take vintage/issuer views between the two. In addition, carry costs and bid/ask spreads could make rolling the index less appealing."
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