A market anomaly in underlying benchmark yield curve dynamics has caused two-year auto paper - historically the most difficult sell in the capital structure - to be shortened slightly and indexed off EDSF rather than interbank swaps. The investor community has demanded this structural change in reaction to current secondary-market quoting methods.
The most recent transaction to experience this phenomenon was last week's $1 billion series 2003-5 deal from American Honda Finance, which saw its A3 notes structured to a 1.95-year average life. It was the second time this year Honda has used the structure, following its Oct. 23, 2003-4 offering. Since the start of November, auto securitizations from DaimlerChrysler and Nissan Motor Credit have also utilized this structure.
The driving factor is that, in the secondary market, fixed-rate bonds with average lives of less than two years are quoted off the eurodollar spot (E) curve, rather than swaps. Given the current yield curve steepness, investors report EDSF behaving more akin to the E-curve than the front end of the swap curve.
"The entire E-curve is used to discount the cash flows; whereas, when using EDSF just one point off of the curve is used to discount all the cash flows," an investor explained. "Given the current upward sloping yield curve for swaps, the E-curve spread will be closer to the spread to EDSF given the same dollar price and yield. The steeper the yield curve, the greater the break, or difference between the two," he added.
The net gain for investors benchmarking to EDSF at pricing is approximately four basis points, when marking that same bond in the secondary post-pricing, buysiders reported.
Issuers and underwriters, given the option of changing the structure or further widening spreads for two-year auto paper, have seemingly chosen the former. Banks have begun structuring A3 classes of auto-loan ABS with a shorter average life by tightening the principal payment window when in the structuring stage.
For a majority of the year, investor demand has not favored the two-year class of auto deals, leading to a camelback-shaped yield curve for auto ABS. "As the two-year bond has been the bond slowest in terms of investor demand, we purposely size the bond inside of two years, to minimize its size while keeping it close to two years," noted one banker.
Additionally, investors know that soon after pricing, the bonds move inside of the two-year range, and become more relevant to the E-curve, instead of swaps. "That is the main reason that two-year tranches have struggled a bit this year," theorizes Barclays Capital researcher Joe Astorina. "Investors know that right after closing, the average life is going to drop below two years and they look at what spread they'd earn over EDSF compared to what they are seeing after initially pricing off of swaps."
Whether or not this trend persists depends on the slope of the curve going forward. For example, floating-rate tranches were the dominant coupon type for auto ABS in 2003, but have now virtually disappeared from the market. "We are just taking advantage of the shape of the curve," one syndicate source noted.