A major event for all spread products over the past year has been the accelerated pace of reduction of marketable Treasury debt outstanding. The process of Treasury debt reduction, which began in mid-1997 and which is projected by Chase Research Economics to continue well into the foreseeable future, will have profound implications for all fixed income investors. In the ABS market, there are already signs of a growing "shortage" of fixed income investment opportunities, as new issues from high quality names get scooped up at seemingly indiscriminate spread levels. The outlook for Treasury debt reduction suggests that this is a "new reality" and one that is, ultimately, very bullish for fixed rate ABS (far more on a yield basis than on a spread basis). An examination of some of the Treasury numbers supports this contention.
Figure 1 shows that Treasury debt grew from roughly $1.5 trillion in 1986 to a peak of $3.5 trillion in 1997, and now stands at about $3.0 trillion. The maturity composition of the debt is heavily front-loaded - almost 50% with maturities of three years and under. According to Chase Research projections1, the process of unwinding the debt has only just begun: over the next 10 years, the $3.0 trillion debt is projected to drop to under $1.0 trillion, at a rate of about $200 billion net reduction per year.
What is particularly significant for fixed income investors is the process by which this reduction will be realized. As Figure 1 shows, Treasury notes constitute almost 60% of the outstanding debt, while bills and bonds represent about 20% each. The projection is that notes drop to a 0% share of the debt while bills - particularly 3-month bills - ultimately realize a 70% share! Given the front-loading of outstanding maturities, the next likely "point of attack" for reducing the note supply is the two-year note. This has direct relevance and significance for ABS investors, since the duration of the fixed rate portion of the ABS market is just over two years.
Obviously, there are numerous political and economic factors that could alter this outcome. Nonetheless, the fact that this projection is even being made at this point is at least indicative of market expectations for future fixed income investment options. Accordingly, it will shape near term investor behavior. There are at least three significant market implications or questions that must be considered. First, Treasuries have represented consistent benchmark or reference securities for spread products. New benchmarks must be established for both hedging and linguistic (a yield "spread" to Treasuries can no longer be quoted without recognizing that its meaning relative to the past is continuously changing) purposes. Swaps appear to be emerging as the new benchmark for these applications (even if the implications of this development are likely not fully understood).
Second, what will or should investors buy in lieu of Treasuries, and at what price? Third, what securities will be able to approximate or even approach Treasuries in terms of such risk parameters as liquidity, credit, and cash flow stability?
With respect to the second question, the past year has not been a particularly good time to undertake the task of looking for alternative investments. The Fed has raised the Fed Funds target six times, bringing the rate from 4.75% to its present level of 6.50%. Along with this, fixed rate yields in spread sectors such as corporates, mortgages (residential and commercial), and asset-backeds have risen by about 200 basis points since the first half of 1999.
As Table 1 shows, supply in these sectors, particularly mortgages, has been significantly impacted by the rise in rates. In ABS and investment grade corporates, where issuance volume is flat to higher, it is worth noting that fixed rate issuance is down substantially, reflecting unwillingness to lock in funding in today's high rate environment. The analysis shows that, at this point in time, the supply of fixed rate spread product alternatives is falling concurrent with the $200 billion net reduction in Treasuries. The simple conclusion is that the supply-demand technicals for the fixed rate spread sectors are now very positive.
In this context, we consider what the ABS market had to offer in terms of products, weighted average life profiles and issuers through July 2000. Table 2 shows total fixed rate issuance volume by product and weighted average life. The predominance of autos in the one- to three-year sector and cards in the five-year sector is apparent. In these most liquid sectors of the ABS market, issuance is dominated by such high quality names as Daimler-Chrysler, Ford, GMAC and MBNA.
When we contemplate the spreads at which these issuers have priced fairly sizable transactions, and do so in terms of the Treasury market dynamics, we see that the moniker "Treasury surrogate" is becoming more and more meaningful. These issues are extremely liquid and are priced off the highest yielding sector of the Treasury market.
If the projection for reduction of two years is accurate, the benchmark is poised to experience the richening seen on the back end of the curve. In short, the pricing spreads (to swaps) may appear tight but that is only because the securities offer so much of what investors need - high risk-adjusted yield and liquidity. Moreover, given the lower implied credit rating of swaps (AA), it is becoming increasingly likely that the AAA ABS from these high quality issuers could ultimately be priced at negative spreads to swaps.
On the floating rate side of the ABS market, HELs, Cards, and Student Loans have dominated issuance. Since the typical ABS floater is Libor-based, the impact of the surplus-driven Treasury debt restructuring will be less pronounced on this side of the market. The key beneficiary of the Treasury debt restructuring will be SLMA, which includes both T-bill and Libor floaters in its ABS issues. Recently, SLMA's T-bill floaters have experienced heightened liquidity concerns related to supply expectations for the underlying index, three-month T-bills, which come as a result of the debt reduction program. An important part of the projections for Treasuries is the growth in share of outstandings of the bill sector, which will be achieved through active issuance and maintenance of liquidity of the three-month bill.
As this program becomes more apparent to the market, we anticipate that the TED spread should be far less volatile going forward and should move back to levels seen in the mid-'90s (barring any unforeseen credit crises). Indeed, the tightening trend for the TED spread has already begun. We anticipate that SLMA T-bill floaters, which have lagged this tightening, will ultimately follow suit. Meanwhile, the lag has created an excellent relative value opportunity in the floating rate sector of the ABS market.
1 Chase projections, which are based on Congressional Budget Office Budget Surplus projections, assume that some portion of the surplus will be re-allocated to tax reduction and discretionary spending programs.
