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| Rafael Martinez |
What has been the biggest change recently to the ABS/MBS market? Besides the clear growth of the European ABS market in terms of new issuance and further expansion of the investor base, the most interesting development has been the increased perception of ABS as a commodity rather than a niche product. The increased demand for ABS from new and existing investors, fuelled by the tight spreads in the unsecured markets, has driven in spreads on ABS, with price tiering to a large extent disappearing. The perception of ABS as a generic product has also decreased the amount of time investors are given to analyze primary deals.
Also noteworthy is an increase in liquidity resulting from more traders and total-return investors entering the market. In the last 12 months, for example, some U.S. investment banks have installed at least one trader in London concentrating on the European ABS market. With the increased participation of these active players, one can expect future spread volatility to be more pronounced.
With spreads so tight, how attractive is ABS/MBS?
High quality ABS, from a pure economic risk point of view, remains an attractive investment. Moreover, taking into consideration where spreads are trading for similarly rated paper, for example in the unsecured or covered bond markets, triple-A ABS still has room for further tightening. What is most important to us is that we can invest in high-quality assets and still get decent spreads. As such, ABS comprises three quarters of Fortis Bank's credit spread portfolio at the moment - the rest is in bank and corporate exposure. We have increased our ABS position considerably over the last couple of years, which offers us the flexibility to be more selective in today's tight markets.
What part of the market do you focus on?
Although we can go down the credit curve on a selective basis, we invest predominantly in triple-A floating rate notes. Our investments cover all asset classes and jurisdictions.
On the fixed-rate side relative value can be found as well. A good example is Dutch RMBS, where the five-year fixed rate is trading at 19 bps over LIBOR whereas floating rate securities of that maturity are at 16 bps. Fixed rate is less liquid, and the interest rate risk has to be hedged, but you do get three basis points pickup as compensation.
Do you invest in non-conforming as well as prime assets?
More than 50% of our European portfolio consists of RMBS, of which an important part is in the U.K. non-conforming mortgage sector. Rating agencies have always been conservative toward U.K. non-conforming residential mortgages and apply severe stress testing to the underlying default probability and potential loss severity. Over the life of the different transactions, however, established originators and servicers have been able to show strong performance compared to the initial assumptions. U.K. non-conforming RMBS is indeed the sector within the European ABS market showing the most upgrades in ratings.
What is interesting to see is that the underlying pool characteristics of the U.K. master trust and U.K. non-conforming deals are coming into alignment. More and more interest-only, buy-to-let, and self-certified mortgages are being included in the master trusts, and meanwhile some recent U.K. non-conforming RMBS deals have included prime collateral in their pools. Still, the non-conforming deals have higher credit enhancement levels and offer a pick-up in spread. A typical U.K. master trust trades today at 15-16 bps over LIBOR, while a comparable tranche of a U.K. non-conforming deal would still offer around 22 bps.
How big a problem is the lack of spread tiering within European RMBS?
There is indeed a lack of spread tiering in the market. The difference in house prices and price changes in the various European countries over recent years is often referred to as an obvious reason why there should be more spread differential. However, in analyzing and comparing different RMBS deals, other factors like default probability of the borrowers, servicer capacity, deal structure, liquidity and so on have to be taken into consideration as well. That's why tiering should take place on a deal-by-deal basis, rather than purely on a country-by-country basis.
How have new issues been impacted by increased demand?
The strong demand for ABS in the first six months of this year has shortened the syndication process for primary issuance. Time to analyze a deal is virtually reduced to zero. Placing orders as early in the process as possible, preferably before any deal materials have been sent out, is clearly the message. Down the credit curve it is even advised to place orders on a reverse enquiry basis, just to have any chance of a good allocation. I like to remind investors that in-depth analysis remains important and that some spread tiering remains warranted.
What is your preference for European relative to U.S. ABS/MBS?
The U.S. ABS market is still the deepest by far and the bulk of our investments are still in this market. The non-U.S. portion, however, is the fastest growing. This currently accounts for 40% and is mostly in Europe, with some in Asia and Australia. The European market is indeed our main focus today as we think it offers better credit quality and relative value. Moreover, we have a particularly deep insight into some of our home markets.
Another interesting feature of the European market is access to prime residential mortgage loans. Nevertheless, because of the size of our book, we will continue to rely on the supply from the U.S. market. Sectors we still fancy are home equity loans, credit cards, student loans and the secured loan market.