I think the majority of sectors are fairly priced to expensive. The one area that is still cheap is triple-A synthetic German RMBS deals, with spreads still around 29 basis points due to lower liquidity, whereas spreads on transactions out of the U.K., Netherlands, Italy and Spain are between 13 and 15bps. The problem in Europe is that at the triple-A and mezzanine levels, RMBS spreads see little differentiation across countries. The country premiums have disappeared, which does not reflect the fundamentals of the different mortgage markets across Europe. The German mortgage market is fundamentally stable, for example, whereas the U.K., Ireland, Spain and The Netherlands have the highest risk of market correction and volatility. We recommend sacrificing some liquidity in favor of a stronger credit profile.
What is the most attractive area within the mortgage market?
Unfortunately relative attractiveness is hard to discern. Along with the convergence of MBS spreads between countries, we're seeing a convergence of spreads across different sectors of the mortgage market. Taking U.K. RMBS as a benchmark, tiering has significantly shrunk between prime and non-prime, and almost disappeared between non-prime and buy-to-let. Under these circumstances, we suggest rigorous credit analysis and discrimination to gain value in a rather tight market.
Is there value in moving down the capital structure?
ABS continues to offer value relative to corporates, but that value has definitely shrunk. The relative pick-up an investor can get from going to single-A or triple-B has dropped by up to 50% over the past year. While some of this decline is related to investors taking advantage of the liquidity premium, the rest cannot be liquidity linked, meaning the risk differential has also been eroded.
What is your view on CDOs and how that market will evolve?
CDOs offer the best value in the market in our view. We especially favor leveraged loan CLOs as they have stable asset spreads and tightening liability spreads, and they weathered reasonably well the last market downturn. As performance of the sector continues to be strong and credit protection continues to improve, we expect spreads to continue to tighten.
We think we're at the beginning of a new CDO cycle, where the underlying asset classes are more stable, most of the deals are managed and investors are taking a more critical approach to underlying modelling assumptions and are more aware of shortcomings in the structures.
What impact will covered bond issuance have on RMBS?
We now have three covered bond issuers in the U.K. and I expect others will follow. Basically we see no problem in the two instruments existing side-by-side as they offer different benefits to both the issuer and the investor. We do expect there to be an impact on RMBS pricing given the new BIS regulatory capital guidelines. Currently covered bonds are pricing at 7-8bps over five-year LIBOR while U.K. RMBS is closer to twice that. In the future, we think the spread relationship could possibly even invert.
What new asset classes and structures do you see developing?
Something new we're seeing is the use of trade receivables in the term market. We expect to see more second-tier banks coming in and for the equivalent of the trust preferred structure in the U.S. to be created in Europe. Also, we're seeing an increasing number of hybrid deals, including combinations of debt and equity, cash and synthetics, debt coupons linked to equity performance, and so on. All kinds of things are being done in CDO format--the recent Capital Efficiency Group deal in Germany, which made it possible for SMEs to obtain equity-like financing directly from the market, is a good example of the innovation we're seeing.
What are the major trends you expect in performance--of underlying assets as well as issuance?
In terms of underlying assets, the main trend we see is toward higher losses in the consumer sector in the U.K. We expect the high debt burden, rising interest rates and the change in bankruptcy law to lead to an increase in delinquencies that will lead to losses in consumer securitizations, although this will not be dramatic. If this is accompanied by a cooling in house prices, then the losses will go higher. We expect some correction of the market in The Netherlands and Spain, but are not concerned about the rest of Europe.
As to issuance, we see it continue across the board from all countries in Europe, with no serious change to the geographic distribution. The only difference we see is potentially an increase in cash issuance out of Germany toward the end of the year, as a result of implementation of the True Sale Initiative, but as we have stated before several other issues need to be addressed before true sale cash deals sky-rocket in that country.