Throughout last year, the triple-B minus class became a routine feature in most mortgage-related ABS deals. Late in 2003, however, the real estate sector began dipping below the investment-grade Mendoza line, flaunting a double-B rated class. Already in 2004, nine real estate deals - from both lenders and dealer shelves - have featured these small high yield tidbits, and sources anticipate the trend will take hold. Buysiders, however - even those who recently bought these classes - caution that double-Bs are not for everybody, but only the most sophisticated investor.
The double-B tranches have been slim cuts of the overall offerings, which range from $730 million to $3.15 billion in total size, with the bottom tranche making up barely 1% of the deal on average. The classes are almost exclusively offered in the private, Rule 144A market and are driven primarily via reverse inquiry interest.
"Double-Bs are kind of the big sexy new thing for the market," one syndicate source said. "But the market for junk ABS is not yet established; in fact, it's very thin and more bonds are offered than actually trade."
Citing the private nature of these bonds, syndicate personnel and traders asked to not be identified for this story.
In the last week of January, Countrywide Home Loans Inc. offered its first double-B ever - and one of the largest to date - showing investors $32 million of fixed- and floating-rate notes, at undisclosed levels. Additionally, C-BASS 2004-CB1, ABFC 2004-OPT2 and MLMI 2004-WMC1 have all completed deals containing double-B classes.
Enhancement for double-B bonds is extremely thin. For example, Countrywide's 2004-1 triple-Bs are supported by just 75 basis points of credit enhancement, 100 basis points less than the triple-B minus class.
This is viewed as the final frontier down the capital structure for issuers, as there is little wiggle room below double-Bs. "If we were to see bonds any lower than the double-B level, they'd be pure enhancement and there would be no actual collateral backing them," one researcher said.
During last week's IMN ABS West 2004 gathering, a panel dedicated solely to investments in subordinated ABS drew a full house, in part, to discuss the emergence of double-Bs. Session facilitator Peter DiMartino of RBS Greenwich Capital, before a packed house, asked buyside panelists if the emergence of double-B rated home equity classes is a "potential for froth," where investors seeking yield now may get burned down the road.
"The emergence of double-B plus [rated] bonds is more a sign of froth," said Barclays Capital portfolio manager Bob Ferguson. "If triple-B spreads tighten 150 basis points to 200 basis points, as they have done, it's time to move up in credit and liquidity - not down," he added.
"No two of these bonds are the same," said Hyperion Capital's Michelle Russell-Dowe, noting the varying credit characteristics of the borrower, as well as the
varying mortgage products. Even after admitting that she recently added a portion of double-B plus exposure, Dowe cautioned that this segment is only for the most credit-savvy investor.
Noting that future economic performance may lead to unexpected outcomes for below investment-grade subs, she said, "These bonds are structured assuming a static environment, so if everything remains the same for the next five years, then yes, these bonds will still be rated double-B plus."
"Now they're cheap, but you have to ask yourself where [home equity] subs are going to trade in a year or two from now," another investor said. "This is essentially the first loss tranche, coming at the expense of credit enhancement. In a rising rate environment, when the 2/28 ARM product that is backing a lot of these deals, resets higher, a lot of borrowers may not be able to make payments - and these bonds will be the first to get hit."
Despite the institutional money's caution over double-B bonds, the boom in hedge funds has created demand where there never had been before. "The hedge funds are the yield-hungry investors right now; they are allowed to buy below investment grade and this suits their risk profile," the syndicate source added. CDOs, which have driven subordinate spreads to the point of pre-ramp wind-downs, are typically restricted from purchasing below investment-grade collateral.
Spread information on a discount margin basis is difficult to come by: "There aren't many data points to look at to get you a [general] clearing level," a trader said. "It's a case-by-case basis." As with the development of the triple-B minus bonds, the double-Bs typically price with what looks like fairly rich coupons, if bought at par, for such high-risk bonds. In order to satisfy available funds rate caps, double-Bs price at a significant discount, in the low to mid 80s.
Another trader described levels for double-B bonds as where triple-B minus bonds were four to five months ago. Triple-B minus bonds, which at the start of 4Q03 traded as wide as 800 basis points over one-month Libor, have tightened significantly and now routinely price near 350 basis points over Libor.