June 2008

ASSET BACKED SECURITIES: Through the eye of the storm

Fear about owning asset-backed securities following the sub-prime crisis has created opportunities for buyers with stronger stomachs and a better understanding of the sector, finds Angele Spiteri Paris ... eyestorm.jpgThe sub-prime meltdown saw many banks and hedge funds sitting on a pile of toxic securities that they could not sell. Facing margin calls from brokers, they were forced to sell off high-quality assets in an effort to fund their positions. Logically, that means there is a large number of quality assets floating around which are ripe for picking. Many ordinary equities in the sell-off may have already been bought up. But what about the higher quality, but far less ordinary, asset-backed securities (ABS)?

This is where some fund managers with the skill to sort the wheat from the chaff are finding opportunities. Fear about ABS has created a favourable environment for asset managers with the capabilities to research them. Felix Blomenkamp, senior vice president at Pimco, says that negative publicity surrounding ABS has made investors who are unfamiliar with the asset class uncomfortable, which has led to higher premiums.

“In the current environment you can earn a premium for the lack of transparency and complexity of these assets,” he says.

Many good quality assets were sold by institutions such as Citigroup and Deutsche Bank at bargain prices to try to raise capital and impede further losses relating to sub-prime. This is where the real money is to be made. Buying such ABS at the current prices can see a portfolio achieve attractive returns for taking a relatively small amount of risk.

Bernard Abrahamsen, director of fixed income at M&G Investments, says these assets offer the best balance between risk and return. “As an investor, you get non-distressed assets at distressed prices, so the risk is relatively low. We don’t often find ourselves in such situations.”

In the ABS world, sound financial assets of a company or institution that may not be performing well can be securitised. The assets, once separated from the originator, act as collateral for high-quality securities that are appealing to fund managers and institutional investors.

Valuable assets
Since ABS are essentially illiquid assets converted into tradable securities, the sharp sell-off that occurred in the scramble for capital has not affected the fundamental value of those assets. Hence, managers can acquire first-rate ABS at a fraction of their true value.

But not all ABS provide good value. “It is dangerous to make a blanket statement in this regard,” says Paul Magura, portfolio manager at Aberdeen Asset Management. “Investors take comfort in seeing an active primary market, which is currently lacking in the ABS space.”

Magura says that although there is technically a primary market for ABS, support for it is not from investors, but from the originators.

Yet this relatively inactive primary market could be seen as beneficial for some. Pimco’s Blomenkamp says: “If the primary market is not reactivated over the long term, then this would certainly be of concern since it would signify the death of the market. However, at present the supply-and-demand relationship is actually positive for managers looking at this market since there are no large new issues that could potentially lead to spreads widening.”

Also, a primary issue that has no take up could cause even more trouble than inactivity. Victoria Johnstone, senior ABS analyst at Legal & General, says: “A successfully placed primary issue would add a certain level of comfort and stability that investors are looking for. However, an unsuccessful primary issue would do more harm at present.”

Arguably, a discerning asset manager could view these investments as the silver bullet in a time of turmoil; however, the ride towards improved returns does not promise to be smooth. Spreads may very well widen out again before narrowing to provide more stability. Although the market has snapped back from the levels witnessed earlier this year, spreads are still wide as compared to where they were prior to the sub-prime collapse.

Asset recovery
Some assets could very well recover in price, thus allowing the market to tap into so-called ‘trapped longs’. These are higher priced assets on institutions’ books that they find can suddenly be sold at unexpectedly good prices.

This would result in a release of pockets of liquidity that may very well depress the market. Also, some other high-profile casualties of the sub-prime phenomenon could still come out of the woodwork, sending spreads wider again.

For institutional and long-term investors, this should not be a concern.  Any waves and troughs along the way to reaching their target should not be disconcerting to an investor looking to hold onto these assets for a long period of time. These kinds of investors can withstand mark-to-market risk and as long as they do not require immediate liquidity they can look to profit from the current ABS environment without running the risk of incurring major losses.

As testimony to this choppy outlook, the ABS market rallied quite strongly in April. The demand for less risky ABS backed by sound collateral revitalised the market as investors caught on that there is value to be had. However, ABS sales this year were still low when compared to the same period in 2007 – down a whopping 76%, according to JPMorgan analysts.

According to Blomenkamp of Pimco, the April rally had more to do with the activity witnessed in March than with the market actually picking up. “In March spreads went out massively,” he says. “Therefore the so-called rally was more likely to have been a correction of the overdone spread widening the month before rather than a strong rebound of the market.”

This therefore proves that the opportunity to buy high-quality assets at cheap prices has not yet subsided. Also, the illiquidity of the current market allows managers to command higher premiums for holdings assets whose value has been driven artificially low by the overall market environment.

Ratings concern
Of course, a major issue that must be taken into consideration when investing in ABS is their ratings. Before the market dislocation, the dispersion of spreads between BBB-rated ABS and A-rated ABS showed little discrimination between good names and bad names. This is not so now since ABS investing has truly become a stock pickers’ market, thus emphasising the importance of managers’ strong research capabilities.

According to Abrahamsen of M&G, one cannot rely solely on the rating agencies for reliable data in this regard. “There is no substitute for doing your own research and ensuring the underlying assets and structures are sound,” he said. “You have to make sure there are enough tranches beneath your investment to get eaten up before your investment is impaired, were anything to go wrong.”

Blomenkamp, of Pimco, also stresses this. “We believe the assigned ratings are good indicators as to the quality of the tranche. However we always base our final decision for investment on the research carried out by our team.”

By carrying out their own research, managers can identify the individual risk of each security, which could deviate substantially from the assessment given by rating agencies. “With ABS you need to look at each transaction in its own right and analyse each structural overlay,” adds Johnstone, at L&G. She explains that this scrutiny is what takes the research behind these investments beyond the assigned rating.

Economic caution
Assets behind ABS vary from credit cards to auto loans to mortgages. It is the quality of these assets that must be researched – but macroeconomic considerations are also vital.

“Interest rate developments and changes are important drivers of the underlying trends in the ABS market,” says Blomenkamp.

A manager would also need to look to the consumer market for signals regarding ABS quality. Countries with very leveraged consumers, for example, are to be avoided, while secured lending would be preferable to unsecured lending, in spite of the dip in the housing market.

But what about ABS backed by mortgages – the so-called MBS, the type of ABS most associated with the recent calamity. Not all of them are backed by low-grade mortgages of course, and so some of them can offer attractive investment opportunities, managers say.

For example, discussing residential mortgage-backed securities (RMBSs) M&G’s Abrahamsen explained how a keen awareness of the so-called ‘bigger picture’ could help one make the right choice.

“Within the RMBS market there are regional differences which are a result of what has happened in each country,” he says. “Dutch and UK RMBSs offer good value, while we would choose to stay away from the Spanish market.”

This, he says, is because Spain has seen an oversupply in its housing market with a resultant sharp decline in house price inflation. As an obvious result the RMBS collateralised by these mortgages is vulnerable.

© 2008 funds europe

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