By Dan Castro and Theresa O'Neill, analysts, Merrill Lynch
What Has Changed?
Normally we discuss the impact of supply/demand technicals and credit/prepayment fundamentals, but in the current environment, fear and greed are heavily influencing the technical picture, and fundamentals, while still important, have become a secondary factor.
Who is afraid? Issuers and investors. Issuers are worried about refunding maturing debt, wider spreads, access to the market, Y2K, and tepid demand from investors. Investors are worried about liquidity, supply, spreads, headline risk, the impact of other markets, and credit risk.
Who is greedy? Everyone, particularly issuers and investors. Issuers are looking for access to the market at the lowest possible cost. Investors are looking for liquid, high credit quality bonds at the widest possible spreads. Lamentably, the disconnect between investors' and issuers' view of the market has exacerbated the recent spread widening.
We have revised our September forecast downward for public ABS supply from $30 billion to $20 billion. This significant decline of anticipated supply follows a heavy period of issuance volume which began in May. Fear and greed appear to be the culprits.
Issuers' concerns regarding Y2K, market liquidity and investor demand helped to accelerate issuance over the past four months at the expense of fourth quarter issuance. The accelerated issuance volume has taken cash out of investors hands and pushed spreads sharply wider (automobile ABS 33 to 35 basis points wider, fixed-rate credit card ABS 30 to 53 basis points wider, and floating-rate credit card ABS 8 to 11 basis points wider) since mid-May.
So here we are in September with issuers facing significantly higher funding costs to access the ABS market. Given this market environment, some issuers are willing to "roll the dice" and postpone September issuance in the hope that market conditions will be kinder in the fourth quarter.
It is our opinion that spreads and demand will not be any worse, post-September, for top-tier issuers in the credit card and automobile ABS sectors; the environment is likely to be challenging for most others, however.
For their part, investors have been, and continue to be, greedy (why not?). Many investors, such as insurance companies, have been adding to their ABS holdings as spreads have widened. Other investors, such as some money managers, have held some cash back in anticipation of buying ABS at wider spreads during the last four months of the year.
Our view, is that we may already have seen the wides for the year, although the potential exists for new wides to be set at slightly wider levels in some sectors of the market.
Our advice: back up the truck and load it up! The downside potential in most ABS sectors is limited, while the upside is reminiscent of October 1998 - the storm may not yet be over, but the clouds will be clearing soon.
What Else Is Important?
Liquidity and credit risk will remain critical drivers of spreads as the ABS market makes the transition into the fourth quarter and then the new millennium. In the short term, the market will continue to be bifurcated based on perceived liquidity, at least through the end of the year.
We believe the liquidity premium for out-of-favor sectors and off-the-run issuers is probably near its maximum for this market cycle. Investors who have the capacity to layer in less liquid ABS (near prime Autos, retail credit cards, equipment backed, and selected Real Estate related ABS) should not be on the sidelines, the liquidity premium should be smaller early next year.
As liquidity premiums diminish over the next six months, we believe investors will place a greater emphasis on credit risk. In the current environment, liquidity and credit risk form the primary basis for tiering within most ABS sectors, and that will remain true going forward. As we move into next year, the focus on credit risk as a greater determinant of spread levels should increase.
Recommendations
Although the supply spigot has been turned back a notch, steady issuance should keep the bias toward slightly wider spreads through the end of the quarter. The retreat of spreads back near historically wide levels coupled with the knowledge that the onslaught of heavy ABS issuance will end in the fourth quarter, leads us to the conclusion that the pain is almost over in the non-real estate sectors of the market.
We repeat our view that spreads will retrace most of the widening paths taken over the past four months by early next year. We still recommend a liquidity barbell in the non-real estate sectors of the market. Automobile and credit card ABS will still provide the best liquidity. The less liquid investments should include non-prime automobile ABS, retail credit card ABS, equipment loan ABS, and subordinated B- and C-pieces with single-A and BBB/Baa ratings.
