An interesting facet of the asset-backed securities market is the ability some issuers have to shift the percentage of bonds they issue between fixed- and floating-rate deals to meet investor demand. The latest manifestation of this phenomenon is the heavy issuance of floaters during the first half of 2000. In a typical year, floaters account for roughly 35-40% of the overall ABS market. So far this year, floaters are running around 55%. This shift helped the market's increased appetite for floaters (due to an environment of concern over the Federal Reserve rate hikes and an inverted yield curve). Several factors influence the overall fixed/floater ratio. The mix varies within some ABS sectors according to changes in interest rates and business cycles. In other sectors it shifts in response to investor demand. In others, it is not influenced by any of these forces.
Sectors Showing Little Change
In some sectors, both collateral and securities are either entirely fixed or all floating. For ex-ample, almost all student loans are indexed to three-month Treasury bills, and virtually all student loan securities are issued as floaters (some linked to T-bills, others to three-month Libor). On the other hand, almost all auto loans are fixed-rate, and ABS securities issued from that collateral are nearly all fixed. To the extent that one of these sectors expands market share, it influences overall distribution of fixed versus floating. In 2000, for example, one of the largest ABS growth areas has been student loans, which is contributing to the overall increase in the percentage of floaters.
Long Term Shifts
Some types of collateral shift between fixed- and adjustable-rates. This has occurred primarily in mortgage-related ABS areas. In the early years of the home-equity market, virtually all collateral was issued via fixed rate loans. Beginning in 1995, adjustable-rate loans started to become popular. By 1997-1998, there was roughly an even split between fixed- and adjustable-rate mortgages home-equitys.
Currently many issuers have strong preference for hybrid ARMs. In part, this is driven by a desire to use prepayment penalties. And in some states, it is easier to use prepayment penalties on adjustable-rate loans. Also, issuers prefer hybrid ARMs over traditional ARMs because the former reduces the number of loans that re-finance in the first few years. Homeowners also like it because (a) the starting rate on hybrid ARMs is lower than on a fixed-rate loan; (b) they avoid any increase in monthly payments for several years (with a traditional ARM they might), and (c) they will not have to refinance to gain advantage of a rate decline once the fixed period expires. Today most home equity ARMS are 2/28 or 3/27 hybrids.
Traditionally, virtually all manufactured housing loans were fixed rate. However, in recent years most MH lenders have introduced ARM products just as exists in the subprime sector. Several issuers, such as Vanderbilt Mortgage and Finance and Oakwood Homes, now include floating-rate classes in their deals backed by ARM collateral. GreenPoint Mortgage Co. alternates between deals that are largely floating and those that are all fixed. GreenTree/Conseco Finance typically does not include a floating class. So the percentage of floating-rate securities in this sector can be sensitive to shifts of market share among MH issuers.
Short Term Shifts
While less of a factor than in the Agency market, a borrower's choice of ARM vs. fixed-rate is also influenced by the level and shape of the yield curve. High rates typically lead to a greater percentage of ARMs, since borrowers do not want to lock in the higher rate for a long fixed period. Also, a steep yield curve makes floating rate product more attractive relative to long-term fixed mortgages, but the most important variable is the level of rates. Some of the increase in home-equity ARM product is related to the higher rate environment.
Fixed or Floating From Same Collateral
To minimize collateral-to-security mismatches, issuers typically structure fixed-rate bonds from fixed-rate collateral and floating bonds from adjustable-rate collateral. However, in several important sectors, floaters are structured from fixed collateral and less frequently, vice versa. The most important example of this is in the credit-card sector. Most credit card accounts are floaters based on the prime rate. However, ABS card issuers will adjust the type of security they issue, i.e., fixed or floater, as well as maturity, to meet investor demand.
As shown in Table 1, the percentage of floating-rate credit-card deals is typically around 60% to 70%. However, in periods of heavy demand for floaters, this percentage can go up to 85% or more. In periods of heavy demand for fixed, it can also drop to less than 40%.
In the home equity sector and, to a lesser extent in autos, the first cash flows from fixed collateral are sometimes structured as floaters. Since there is minimal risk of a serious rate mismatch over this first 12-month period, the rating agencies feel comfortable in allowing issuers to issue these short floaters from fixed collateral. The choice of fixed vs. floater for the short cash flows will depend on relative spreads and the demand for short floaters
Big Shift To Floaters
Several of the forces that can influence the floater percentage were at work in early 2000. They have combined to push the percentage of floaters from 35% to 39% in 1999 up to 58% in Q2 2000. Table 2 gives a breakdown of the major ABS sectors and the percentage of floating rate bonds issued during 1999 and the first half 2000. As the table shows, there has been a dramatic change in several individual sectors, as well as in the overall percentage of floaters.
Credit cards issuers, known for switching issuance to meet market demand, shifted almost entirely to floating-rate in early 2000. The card floater percentage increased from around 65% in 1999 to around 85% in the first half 2000. Another major contributor to the increased percentage of floaters was the sharp growth in student loans. Student loan issuance has already reached $8.8 billion this year - that's well ahead of the $8.1 billion issued during all of 1999. Since virtually all student loan ABS is floating-rate, an increase in that sector will raise the overall percentage of floating-rate securities.
The floating-rate percentage for home-equitys has also shown a marked increase. As mentioned earlier, many issuers are stressing hybrid ARM production. Also, since there is a surplus of collateral, and issuers feel they can get better execution on their floaters, they have been choosing to securitize a higher percentage their ARM production. There has been an increase in the floater percentage in the "other" category, but this is mainly the result of a shift in the composition of this category, rather than a shift to a higher floater percentage within individual groups.
As can be seen in Table 2, the floater percentage is unusually volatile in this "other" sector because of the composition shift from quarter to quarter. Also, this sector is running well behind last year in volume, and hence, will have only a minimal impact on the overall floating-rate percentage.
Non-Public Issuance
Aircraft leasing is one of the growth sectors of the ABS market. However, most of these deals have been brought as 144A securities so they do not appear in Table 2. In 2000 so far, of the $2.9 billion in aircraft ABS securities issued, roughly 80% have been issued floating-rate. We expect this sector will continue to contribute to the availability of floaters in the months ahead. More importantly, 75% to 80% of the securities from the CBO market (another 144A sector) are floaters. Because this market sector is so large, when it expands, it can significantly increase the amount of floating-rate securities available to investors.
Outlook
The shift to a higher floater percentage over the past several months has not only helped meet a growing investor demand, but it also helped the fixed-rate market. A larger volume of long-dated cash flows in the credit-card and home equity markets would have made those sectors' indigestion problems even worse.
We doubt that the tilt toward floating-rate issuance will change dramatically until there is more persuasive evidence that the economy has really slowed, and that the Fed has completed its tightening activities for the time being.
There's a better tone in spread markets, including the ABS market, and demand for floaters may not be quite as intense now as it was in the weeks past. However, we think the market needs to see a few more months of restraint on the part of consumers before there will be a noticeable shift back to a higher percentage of fixed-rate bonds (in the sectors where issuers have that option).
