Spreads on everything except sub-prime stuff has been racing in. And its got me a little nervous that a true mania in credit might develop.
First the bad news: The ABX 2007-1 BBB- keeps hitting new lows...
Hard to hold out a lot of hope for Baa-rated sub-prime pools. I saw a pool offered by Goldman Sachs at a dollar price of $10 yesterday. It was originally rated Baa, now C. It was a 2006 vintage, so the loans are probably less than 2 years old. Just for fun I ran it through some modeling and found that if the current delinquency rate (15%) turns into a default rate, and the recovery is around 50% (generous), even at a $10 principal price you'd still wind up losing money. Bear in mind since the loans were probably less than 2 years old, there probably haven't been any resets yet! I didn't spend a lot of time on this particular piece so this is hardly complete analysis, but the point here is that there is a lot of shit out there that ain't coming back.
Meanwhile, asset-backed CP rates are improving dramatically. The following compares ABCP vs. 3-month LIBOR:The ABCP rate is from the Fed's H15 release, and its only been tracked since 2006. But you can see that there was virtually no volatility in this rate until suddenly there was. This graph combined with the next graph on amount outstanding in ABCP:
ABCP outstanding looks a bit Beggar's Canyon back home eh? If you think about these two graphs together, my belief is that most of the bad actors in this space have been denied access to the CP market. So spreads are tighter on ABCP because the only issuers left are the stronger issuers. I'm hearing its mostly corporate guaranteed paper, i.e., a strong bank who has put a corporate guarantee on the SIV or whatever conduit has issued the CP. I think its important to realize that the concept of ABCP isn't a bad one. Hell, I think a lot of investors would prefer to have their CP backed directly by quality assets as opposed to being subject to corporate shenanigans. Currently the definition of "quality" has come into question, and the ABCP market is suffering for it, but in the long run, the ABCP market should be fine. That being said, I'm a little surprised its improved this much this fast. Its getting me just a little nervous
High yield corporate spreads have moved much tighter as well:That's two years worth of data. Obviously this shows the big downward trend in spreads. I've said that I was constructive on high-yield, and I am still. But there is potential here for a mania phase to develop. Let me draw out a scenario...
- High Yield spreads "correct" from unusually tight spreads in response to problems with sub-prime mortgage loans. (already happened)
- HY spreads rapidly tighten back, not quite all the way to the previous tights, but maybe half way.
- People start justifying the move by claiming that the HY market never had anything to do with sub-prime anyway. So, they'll claim, the widening of HY spreads was not fundamentally justified.
- HY spreads keep tightening, blowing through all-time tight levels. This encourages more borrowers to come to market. LBO and covenant light deals re-emerge.
- This causes the same problem we had in sub-prime: too many deals. Marginal borrowers are always the weakest borrowers, be it consumer or commercial loans.
- Default levels rise significantly, and HY spreads gap out tremendously. See 2001.
So at 400+bps, there is value to high-yield. But be cautious. If a mania phase develops, don't fall for it. I'll be happy to unload my high-yield position at 300bps or so and watch the mania from the sidelines.