While spreads in the real-estate ABS sector near historical wide levels, the out-of-whack supply/demand dynamics are reverting to the norm, which has analysts predicting 15 to 20 basis point of tightening in triple-As by the end of the first quarter 2003.
While all agree that home equity and real estate ABS has become cheap, the Street is mixed as to where the best opportunities currently present themselves. Most see strong demand for triple-A rated bonds at current levels, but there are conflicting views on down-in-credit subordinates, which have widened roughly 200 basis points versus Libor in the second half of the year for triple-B rated new-issue supply.
Lehman Brothers analysts note in this week's MBS & ABS Strategies that triple-A floaters have widened 20 basis
points since reversing course this summer. Meanwhile, single-As have widened approximately 80 basis points.
As predicted last year, issuance in the sector has spiked, topping $100 billion throughout the first three quarters of 02, and spreads have widened in accordance. But while it is easy to blame the tailspin in spreads on the staggering amount of supply seen this year, there are demand-side dynamics at work as well.
One point of view is that the current wide levels predominantly reflect fears of subprime borrower credit, according to Banc One Capital Markets mortgage researcher Glenn Schultz. Shultz believes that the underlying credit of the borrower is stronger-than-expected and that the majority of borrowers in these pools are not prime because of a single credit event in the past.
Shultz basically views the decision as a bet on the sub-prime borrower in the current economy - believing the odds are in their favor. Borrowers will outperform expectations going forward, leading to hefty tightening through April, he said.
Even if, as expected, home values decrease marginally, loses should be tempered. "Just because the value of a borrower's home decreases slightly, doesn't mean he is going to hand over his keys and default on his mortgage," Shultz said.
Merrill Lynch analyst Josh Anderson concurs that spreads for triple-A home equity paper are currently at attractive levels, and that tightening is likely going forward. But, Anderson thinks that triple-Bs will remain under pressure, partly due to the lack of a natural buyer base. Triple-As, he argues, will be bolstered by increasing agency buying going forward.
In its weekly outlook, Lehman points out that demand for triple-Bs has dried up, due to "significant widening of liability spreads in that market," reducing the arbitrage value for asset managers.
But whether there's a lack of demand or too much supply, the result is the same, notes Mark Adelson, head of ABS research at Nomura Securities.
One area of increased supply, issuance from dealer shelves has already calmed somewhat from the madness that bid whole loan portfolios to record highs. Should the economy turn around in 2003, and interest rates subsequently rise, refinance activity would decrease.
When the supply/demand dynamics return to normal, over the next three to four months, spreads are seen tightening. Lehman predicts that spreads for triple- and double-As will contract 10 to 15 basis points and single-As will tighten 30 to 40 basis points. Triple-B recovery is expected to take a bit longer than its higher-rated counterparts, as the arbitrage dynamics correct themselves.