In a research report last week, Morgan Stanley's ABS research team examined the relative value of combining a double-A/double-B plus trade, versus a standalone triple-B minus trade in the home equity sector, showing that on both a credit adjusted and option adjusted spread basis, the double-A/double-B plus combination enhances yield and improves the default risk profile compared to buying triple-B minus bonds alone.
The reasoning behind the trade is that a substantial boost in yield can be gained by going only one notch lower than triple-B minus in the capital structure to a double-B plus credit, while hedging credit exposure by moving up seven notches to the double-A bond. For the triple-B minus trade, Morgan Stanley used the weighted average spread for a typical mezzanine ABS CDO, with a triple-B WARF for assets, and for the double-A/double-B plus trade the firm used a sub-investment grade ABS CDO, with a double-B plus WARF for assets.
The spread neutral trade would be a 67% double-A and 33% double-B plus combo, netting the 122 basis points achieved through the triple-B minus alone. But an even double-A/double-B plus split would boost yield by about 76 basis points, netting a spread of 198 basis points. By doing so, 50% of the risk is allocated only one rating notch lower, and 50% of the risk is hedged by going seven notches higher in credit while picking up 76 basis points of net credit-adjusted OAS and other risk premiums.
Of course the double-A/double-B plus combination is more sensitive to the absolute loss level since the double-B plus bond is the most subordinated bond in the firm's analysis, suffering its first dollar principal loss at 6.8% cumulative loss level. However, the level of losses between the double-B and triple-B minus bonds are only separated by a narrow 70 basis point margin of 7.5% to 6.8%. In addition, the firm's combo trade is only half exposed to this credit risk. Additionally, should collateral losses hit the double-B plus at 6.8% cumulative loss, it is likely that if losses are enough to eat through the double-B plus bonds, the triple-B minus will likely suffer some amount of principal loss as well.
Since the combo trade is a hedge against principal loss, triple-B minus credit is completely wiped out at 10.9% cumulative loss, while under this scenario, the combo trade would still be 50% protected due to the double-A exposure. Morgan Stanley notes that with this trade, the double-B plus tranche enhances yield, while the double-A tranche provides "some level of principal protection." In addition, the combination trade could be custom-tailored to provide an appropriate level of risk.
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