Structured credit markets still look unattractive

Credit markets have enjoyed a fairly strong rally over the last few weeks, with spreads back to levels seen at the beginning of September. Some of the biggest gains have been in the areas that previously saw the largest losses, although asset backed securities (ABS) and mortgage backed securities (MBS) have still been among the biggest losers since the financial crisis began in June. One type of money market, the Asset Backed Commercial Paper market (which is used by many financial institutions for short term financing) has contracted from $1.3tn to $900 billion since the crisis began.

UK MBS backed by residential mortgages has suffered from the US crisis and Northern Rock debacle. Bonds that were rated AAA and yielded LIBOR + 10 basis point widened out to LIBOR + 50 basis points, although AAA spreads have tightened a little recently. Some BBB rated issues that were once yielding LIBOR + 50 basis points have widened out to levels usually associated with junk. Five year BBB paper now trades at around LIBOR +200.

Even at these levels, we are generally not buyers of residential MBS. As alluded to on this blog, our view is that this crisis has further to run. Credit rating agencies have downgraded lots of lower rated ABS/MBS deals, but are yet to make their move on a considerable number of so-called AAA rated bonds. When this does happen, we expect to see yet more repricing of this area of the structured credit market, and also anticipate some repricing in corporate spreads as former AAA deals crowd out A and BBB corporate land.

Taking a longer term view, it’s likely that residential MBS is going to be negatively impacted by a slowing of the housing market. Residential MBS will be hit hard if house prices fall, as delinquencies will inevitably rise. Slower repayment speeds on mortgage-backed deals will also slow the cycle of money being re-invested in new deals. ABS will not escape unscathed from a worsening consumer outlook either, as they are typically backed by things such as credit card repayments or car loans.

An area that looks a bit more appealing is the collateralised loan obligation (CLO) market – unlike CDOs, the underlying assets in CLOs consist entirely of leveraged loans, which are on the whole trading at attractive levels.

 

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