Is the impact of Basel II already reflected in spreads or do you recommend buying triple-As in anticipation of further tightening?
The impact of the new Basel II regulatory framework is only partially reflected in triple-A spreads. Spreads on residential mortgage-backed securities and on structured covered bonds ought in fact to converge. At the moment, spreads on most covered bonds range between LIBOR minus three or five basis points to LIBOR plus three to five basis points, while spreads on prime RMBS are closer to 12bps over. So there's still good leeway and we don't expect covered bond spreads to widen to meet RMBS spreads. RMBS spreads have already come in from about 25bps over in anticipation of Basel II implementation but there are still a lot of questions regarding the timing of implementation and the precise form it will take in different jurisdictions. Some investors won't be happy with further RMBS spread tightening but at the same time it will open up the asset class to new investors.
How do you see the market developing for credit default swaps on ABS?
Some private deals have been done but for a public market to develop there needs to be an index on which the whole industry can agree and where participants have transparent access to the underlying data. What makes this especially problematic in ABS is that 80% of the market is floating-rate, while existing indices typically include fixed-rate bonds, so a new index will take that much longer to develop. Also, investors aren't crying out for an index, since most reference LIBOR. Another issue that I see in the development of CDS of ABS is that the assets, in particular CMBS, are highly prone to idiosyncratic risk, which means that if one were to just average out individual spreads to create an index, an investor using the index would have very high basis risk. If deals were to become more standardized, that would lessen this risk. In any event, I don't expect CDS of ABS to take off this year.
CMBS was tagged as major growth area for 2005--how is shaping up?
We have almost reached the level of issuance in Europe year-to-date that we reached for the whole of 2004: $20 billion of CMBS has been issued so far this year versus $26 billion for the whole of 2004 and that was already more than twice what was issued in 2003. Most of the issuance is out of the U.K., although more and more deals are including collateral from the Continent, from Germany in particular. What's driving this are CMBS spreads that are the lowest they've been in four or five years. Spreads on triple-A CMBS are now around 20bps, significantly tighter than the 40-50bps we saw as recently as early 2004, and property owners are switching syndicated loans into securitizations.
Where do you expect to see the greatest growth next year?
CMBS will continue to be a growth area and we'll also see more SME CLOs [collateralized loan obligations of loans to small-and-medium sized enterprises] as smaller loans are funded through the capital markets rather than by banks. The market for SME CLOs was expected to take off this year but it hasn't in fact emerged in size yet and we don't expect this year's volumes to exceed last year's $16.6 billion. So far we've only had about $7.7 billion in issuance, the bulk of which came in HypoVereinsbank's Geldilux transaction earlier this month. Often SME CLO transactions are loaded toward the back-end of the year, when issuers need to address capital relief and accounting concerns. Also, if we're going to get more banking consolidation in Europe next year, we would expect an increase in SME CLO issuance as the merged entities seek to restructure their balance sheets.
Where can investors find value in this tight-spread environment?
I would rephrase the question: it's rather, how can investors avoid losing money. We don't see much upside in the ABS sector, as valuations are rich across the board. A conservative bet would be to stay with high-quality assets such as prime residential mortgage-backed securities, as these will be the most stable. We would stay away from credit cards, as spreads in the sector are very tight compared to RMBS, and the asset class could come under credit stress if the consumer comes under pressure. At the triple-A level, credit card ABS trades about four basis points inside RMBS, which isn't really justified. At the triple-B level, we've already seen some leveling out of this differential.
Do you see spreads on secured versus unsecured bonds converging or decoupling?
The lower you go in the capital structure, the more correlated you'd expect the spreads to be. Recently, however, we've seen more correlation at the triple-A level than at the tripe-B level, which is counterintuitive. Going forward, we expect to see higher correlation in spreads at the triple-B level. While triple-B ABS is less insulated from credit risk, buyers are typically buy-and-hold investors, so even if you'd expect to see higher correlation we might just not have seen it yet since these assets don't get traded very much. The correlations between spreads of secured and unsecured paper will inevitably increase because the yield differential is just so big.
What new asset classes and structures do you see developing?
ABS from new jurisdictions is going to be a major growth area, in particular from Eastern Europe and the Middle East, as more mortgage financing is getting done in those areas. It's largely being driven by expatriates who want to take advantage of rising property prices and the housing market is booming in those regions, albeit coming off a low level. Given the different regulations in these jurisdictions, it's likely that deals will need to be structured differently to accommodate legal requirements. For example, new ways might need to be devised to get full security on a property, such as by offering additional guarantees or safeguards. In addition, I expect we'll see more state-related future flow transactions, like the German pension deal.