CreditSights: The Week In Credit
The market was awash with bid lists last week as the continued route in the interest rate markets rolled into the corporate sector and investors looked to cut exposure given how fixed-income technicals are souring. Among the names on offer was a heavy representation of auto paper and earlier in the week we shifted our recommended allocation on the sector from Overweight to Neutral. We expect that the technical pressure that is already being exerted on auto spreads will be more than what would normally be associated with a bout of profit taking after a period of outperformance. This is because the sharp contraction in auto spreads has taken place at what we believe to be the end of the nine-month bull run in credit product and as investors look to scale back overall exposure, the double-edged sword of "liquidity" comes into play. When bondholders look to take down exposure quickly, the go-go names are always prominent on the early bid lists. The fact that Ford Motor and General Motors are consistently the most actively traded names in the secondary market leaves the auto sector firmly in the crosshairs of the selling pressure. According to MarketAxess, in the second quarter Ford paper alone accounted for 7.06% of secondary market volume. GM/GMAC trades accounted for 5.46% and these numbers are, if anything, slightly understated by the TRACE reporting process. So, with one-eighth of market turnover being in auto paper, there is no escaping the selling pressure that the sector will feel in the midst of an overall move to cut exposure to corporates. Auto paper as the hedge vehicle of choice for credit product will not help much either in the stretch to year-end seasonal pressures.
For a sector that remains in favor, a softening in spreads after a strong run will usually be met with another round of buying once it is determined to have become "cheap enough." The difficulty with remaining positive on near-term prospects for auto paper lies in answering the question: what is cheap enough to bring in a fresh round of buying? The sector still offers a more generous pick-up to aggregate option adjusted spread than any other part of the investment-grade arena. And three-month breakeven spreads at 12 basis points are three times that of most other sectors.
Being aggressive about positioning and playing the spread range in auto paper has been a winning strategy in 2003 as the sector has been unable to deliver consistent excess return, despite its wide spread levels. The technical argument to reduce exposure is strong. The fundamental case is more divided as the jury is still out on where the cycle in general is headed and more narrowly on what the original equipment manufacturers will be able to accomplish in this UAW round. Nonetheless, the seasonal trough in automotive earnings is upon us and there is no end in sight to the competitive pressures, the pension legislation ideas in Washington get more convoluted by the day, and the latest signs from the consumer were surprisingly weak. That does not signal much hope for a fundamental rescue near term from the technical risks.
Analysis by CreditSights, Inc., an independent online credit research platform. Call (212) 340-3888 or visit www.CreditSights.com for more information.