On average, the asset coupon of a triple-B rated ABS in a CDO portfolio is Libor +175-225 with a funding level of Libor +45-50 on the triple-A rated class. Compare this to a high yield CDO, whose average asset coupon is Libor +275-325 with a funding level of Libor +40-45 on the triple-A rated class. While the spread arbitrage is not as great on the ABS CDO, more leverage may be employed because of the portfolio's higher credit quality. The increased leverage opportunity in the ABS CDO results in comparable, if not greater, expected return on equity. The question is then posed: Does this asset class justify the increase in leverage when used in a CDO?
To date, the CDO market has issued a total of ten transactions that are backed primarily by a portfolio of ABS mezzanine classes for a total of $3.3 billion. We expect issuance of CDOs backed by mezzanine ABS to continue as long as the arbitrage opportunity remains economic. In addition, we expect that ABS CDOs could cause spread tightening within the mezzanine ABS sector as demand for these tranches increases.
Liquidity: Triple-B ABS Versus Triple-B Corporate Bond
Compare the spread of a five-year, triple-B rated credit card ABS, the most liquid triple-B rated ABS in the sector, to that of a corporate bond with similar ratings and maturity. The ABS will have a spread to Treasuries in the range of +180-190 basis points, while the corporate bond will have a spread to Treasuries in the range of +135-160 basis points. Even in the most liquid comparison scenario, the yield difference between the two is considerable. The following factors contribute to reduced liquidity in lower rated classes of ABS transactions:
*Small tranche and deal sizes;
*Reduced investor base (often due to non-public status
and/or non-index eligible);
*Different skills required to analyze transactions;
*Increased time required to understand credit, structure
and issuer; and
*Fewer dealers supporting each deal.
Flip Side: Minimal Default Risk
Default studies between structured transactions and corporate bonds reveal a strong case for the former. Standard and Poor's Ratings Co. conducted a default study of all S&P rated ABS between 1985 and 1999, including public and 144A transactions (see U.S. ABS Credit Ratings Show Solid Performance, 1985-1999, Joseph Hu, Ph.D., January 2000). The result of the study was simple: S&P identified zero defaults. Follow-up conversations with Dr. Hu revealed that the term default was defined as the incidence of a single dollar of missed interest or principal.
These default statistics are mirrored in a report by Moody's Investors Service dated July 14, 2000, entitled Rating Changes in the U.S. Asset-Backed Securities Market: 1999 Second Half Update, by Joseph P. Snailer. According to this report, only one security originally rated Baa3 or above was downgraded below Ba3 during1988-99, and none are reported as having defaulted. In addition, for the purposes of this study, Moody's used public, private and 144A issues.
We compare these results to those of corporate bonds by using another study by S&P - Corporate Defaults Rise Sharply in 1998, dated March 1999. This report revealed that in the 17-year period of 1981-98, corporate credits' five-year transition rates showed that 12.16% of triple-B rated corporates were downgraded to double-B or below and 1.88% defaulted. For illustrative purposes, we also include the transition and default rate for double-B rated corporates, typically the highest level credit found in high yield bond CDOs. During the same period, 10.96% of double-B rated corporates were downgraded to B or below and 9.94% defaulted.
We concede that the S&P and Moody's default statistics on ABS may be slightly misleading without consideration of other factors. For one, we are aware of a limited number of situations in which defaults have not yet occurred, but ultimately will. Furthermore, if studies were available on Fitch and Duff & Phelps rated ABS transactions, they would reveal more than zero incidences of default. No asset class is perfect and unfortunate incidences occur even in the ABS market. Notwithstanding its blemishes, we still contend that the incidence of default is significantly lower in the ABS market.
Stability in Ratings Enhances Argument
Assessing rating downgrades is another way to capture the likelihood of future default. In the next section, we conduct a comparative analysis on rating downgrades in the ABS and corporate bond markets, which reveals considerably greater stability in favor of ABS.
As shown in Figure 1, only 1.44% of triple-B rated ABS were downgraded to double-B or below, compared with 8.63% of triple-B rated corporates during 1985-99. The ABS statistic of 1.44% remains the same when totaling all investment grade rated transactions that fell below investment grade. However, the five-year transition rate for corporates reveals that 18.32% of investment grade corporates were downgraded to below investment grade. Another important consideration is that a majority of ABS downgrades reflect a change in the credit rating of the guarantor, the provider of a Letter of Credit (LOC) or bond insurance, rather than deteriorating pool performance.
Ratings vs. Default Risk in ABS and Coporates
We argue that ABS and corporate ratings do not convey the same default risk, and we identify clear, anecdotal evidence with events that unfolded in 1998 for Advanta Corp.
Advanta Corporation was once one of the ten largest issuers of credit cards. While it operated other business units, the credit card business was its largest and most profitable asset. The company encountered financial difficulty late in 1997 and early 1998 and subsequently sold its credit card business to Fleet Financial in February 1998.
We compare rating changes of Advanta's unsecured debt and credit card ABS before and after the financial difficulties. For an apples to apples comparison, we chose Advanta National Bank's unsecured bank deposit notes and the class collateralized invested amount (CIA) of the Advanta Credit Card Master Trust, series 1998-A. Each of these securities carried a Moody's rating of Baa3 at the beginning of 1998.
Following the sale of the credit card business to Fleet Financial, Moody's lowered the ratings on Advanta's long-term bank deposits to Ba2 from Baa3. The current ratings remain at Ba2. These bondholders were clearly at a disadvantage and experienced significant price volatility on their holdings. Conversely, the holders of the Baa3 rated ABS saw no rating changes, less price volatility and benefited by virtue of the sale to a stronger, well capitalized servicer.
Why Are ABS Ratings More Stable?
We concede that ABS rating transition frequency is not directly comparable to that of corporate bonds. However, we believe that the considerable difference in ratings migration and absence of defaults are sufficient testaments to demonstrate the sheer stability and lack of default risk in ABS transactions. In the next section, we explain why a triple-B rated ABS is superior to a triple-B corporate from a default risk perspective. A corporate bond represents an unsecured promise to pay principal and interest on borrowed money by one company in a single industry. Conversely, an ABS is collateralized by a pool of receivables that is:
*Isolated to a bankruptcy remote trust;
*Secured (except in the case of credit cards);
*Designed to withstand stressful default and loss conditions on an ongoing basis; and
*Supported by some form of credit enhancement.
On the last point, it's important to clarify that not only senior ABS securities benefit from credit enhancement. The mezzanine tranches of ABS usually have considerable credit enhancement below them in addition to excess spread. The bankruptcy-remote structure attempts to protect the transaction from the most dire situations the issuer can encounter. Furthermore, the following structural protections have been designed to protect the ABS transaction from substantial deterioration and are common among certain types of ABS:
*Early amortization events for most revolving structures. Triggers to an early amortization event include bankruptcy of the seller/servicer and poor performance of the underlying receivables. This feature is designed to assist the unwinding of the transaction as soon as deterioration is detected.
*De-leveraging of sequential structures. In transactions that do not revolve, but rather pay down with the collection of principal payments on the underlying receivables, it is common to first pay off the most senior securities. As such, significant de-leveraging can occur, leaving the lower-rated classes in stronger positions. However, we note that more recent structures allow for the paydown of subordinated securities after certain "cross-over" dates and this deleveraging is not as great within these structures.
Implicit Issuer Support
A large majority of ABS issuers are dependent upon the securitization market as a primary source of funding. Such reliance has resulted in the issuer taking certain actions to improve the performance of the ABS. In the absence of supporting actions, the ABS may have been downgraded or entered an early amortization. These actions have been at the expense of disapproving regulatory oversight, but have enhanced the ratings stability history of ABS.
Putting aside the extreme difference between ratings stability of ABS and corporate bonds, investors in CDOs backed by ABS should gain additional comfort from the following:
*Low return correlation to other asset classes because of ABS' reliance on the underlying receivables as opposed to traditional credit worthiness; and
*Monthly reporting by most ABS transactions, thus giving the portfolio manager more time to detect deteriorating credits.
For investors who manage a portfolio of CDOs, investing in ABS-backed deals is a great way to hedge against a future downturn in the economy. Because of the bankruptcy remote structure of each underlying asset, a portfolio of ABS is likely to weather a recession with less price volatility and fewer ratings downgrades than a portfolio of corporate debt.
Using lower rated classes of ABS as a CDO asset class is an efficient use of liquidity arbitrage. Simultaneously, investors in ABS CDO transactions can expect stable performance and an extremely low likelihood of impairment of their investment. As with any CDO investment, investors should carefully review the experience and asset selection process of the portfolio manager. In closing, we believe that the stable ratings, extremely low default risk and minimal correlation in a diversified portfolio of ABS are convincing protections that should result in establishment of this type of CDO as an attractive investment to participants in the CDO and ABS markets.