Farmer's Insurance Group got into the asset-backed securities market three years ago in search of alternatives to corporate floaters.

After finding ample amounts of cheap spread product with which to diversify, the company chose mostly vanilla, extremely liquid sectors in which to play, making sure to shore up credit quality under a conservative approach for matching its assets with its liabilities.

The conservative approach continues, as Los Angeles-based Farmer's has only made incremental changes in its buyside habits. The investment company still buys from sectors with rock-solid cash flows like credit cards, still finds value in rental fleet leases, and like many ABS investors, likes to diversify its portfolio with an emerging asset class that has become extremely liquid: the rate reduction bond.

In fact, the changes to Farmer's ABS holdings have occurred mostly inside the structure of the sectors that the company has always played. Instead of floating-rate product, the company now hunts for fixed-rate six-year bonds in the credit card and the stranded-cost sectors.

"All else equal, this is the best roll down the Treasury curve," said Rick Mayfieild of Scudder Kemper Investments, the portfolio manager for the Farmer's account.

"For the California rate-reduction bonds, in the 5.7-year, you saw a spread of plus-89 versus the actual, or plus-105 versus the five-year," he said. "Five-year California RRBs garnered 97 over the bench. That ends up being an eight basis point roll down the for 0.7 years.

"The preferred habitat for most ABS investors is typically five years and ahead, and most insurance companies go five years and out. If you look at credit cards and rate-reduction bonds in terms of the Treasury curve, there's always a bid in the five-year area."

Mayfield said that a reason one can garner spread when buying on the longer end of a five-year maturity is because the buyer is going from an off-the-run Treasury pricing to an on-the-run approach, which can be overly expensive.

Corporates Versus ABS

Mayfield said that heavy ABS supply this month has eroded the attractiveness of this credit roll, as five-year ABS has widened considerably under the deluge. But despite the large volumes and the spread widening that spurred, Farmers has largely watched from the sidelines, parking most of its "smart money" in corporates.

Mayfield said the reasoning for this is simple: better spread.

"Corporates right now, especially in the five-year area, are the cheapest bonds out there," he said. "They're also highly liquid, have good names, and are large issues. They're very compelling because of that. Given that Wells Fargo priced a five-year corporate at 110 over the curve, and MBNA priced its triple-A credit card deal at plus-98 around the same time frame, corporates are overly attractive."

Paul Secord, chief investment officer for Farmer's, said his company has set investment parameters to accommodate for situations such as this when there's a lack of attractive spread product for a certain sector versus others.

"We take a holistic approach to our portfolio management," Secord said. "We do not set any minimums. If asset-backed securities are not attractive, it's possible that we will have 0% of our portfolio in asset-backeds."

Currently, Farmers has 3% to 4% of its bond portfolio allocated to asset-backeds for a total of approximately $475 million. Most of the rest of what Farmers investments in comes in the form of corporates, mortgage-backed securities and municipal debt.

"They're not overly unattractive," said Mayfield about ABS, "but they're not overly attractive either. We have tax constraints, such as whether or not we have gains or losses. Once you factor all of these aspects in, they aren't a sell, but they sure aren't a buy either."

HELs: Too Rich For The Risk

One place the buy and hold insurance company will not go looking for cheap product is in the mortgage-related ABS sectors. Mayfield remains leery of where prices are with the type of credits in the home equity sector especially.

"There's a whole list of things that can happen," he said. "One of the stories behind B and C home-equity loans, is you have these fast prepayment speeds because of curing. Given all that variability as far as cash flows, we feel that option is worth a lot more than the market prices in."

And perhaps Secord put it most succinctly when he said there is no such thing as a bad bond, "just bad prices."

"If the spread is attractive enough, we can make room," he said. But both he and Mayfield stressed that room in the company's ABS portfolio was currently very limited. - SK

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