Thursday, August 21, 2008

Student Loan ABS: Do or do not!

The world of asset-backed bonds (ABS) is in disarray. While home-equity securities have grabbed the headlines, other types of ABS have suffered as well. Student loan ABS are one example of the baby being thrown out with the bath water.

There are two basic types of student loan ABS. Some are constructed with private student loans, and these carry risk of those borrowers failing to make payments. Others are made up of Federal Family Education Loan Program (FFELP) loans. FFELP loans are at least 97% guaranteed by the Department of Education (loans made before July 2006 have a greater guaranty).

Despite the guaranty, the yield spread on FFELP student loan bonds has widened substantially, creating an opportunity for investors looking for income securities which are not significantly exposed to credit risk.

A typical FFELP student loan securitization will include approximate 5 tranches. The first four will usually be labeled something like A1, A2, A3, and A4. These are all senior securities. The last tranch is a junior security, commonly called the B tranche. In the most recent Sallie Mae student loan securitization, the B tranche represented 3% of the entire deal structure, exactly the amount uninsured by the Federal government. This effectively eliminates credit risk for the senior securities.

The four senior tranches pays floating interest quarterly based on a spread to 3-month LIBOR. The spread is set at issuance. In the secondary market, the bonds will trade at a premium or a discount to par based on the relative attractiveness of the original issue spread. Principal on these issues is paid sequentially, with all principal flowing to the A1 tranche until that tranche is completely repaid. Then all principal flows to A2 and so on. As a result, the tranches have very different average lives. Usually the A1 tranche has an average life of around 1 year. The average lives of the other tranches varies from deal to deal, but typically there is a 3-year and 5-year tranche as well.

According to Merrill Lynch, 1-year FFELP student loan ABS currently yields 65bps over 3-month LIBOR. 3-year paper has a spread of 100bps, and 5-year 125bps. These spreads had been relatively constant in the 0-15bps area for several years before widening rapidly last fall. So far in 2008, student loan ABS spreads have moved higher or lower with the tide of liquidity. Spreads peaked in March, tightened in April and May, and have recently widened to near March levels again.

In a fixed income market where many securities are offering historically wide spreads, student loan ABS offer some unique advantages over other short-term alternatives. The structure is most similar to a corporate floating rate note (FRN), but of course the student loan paper has no substantial credit risk. Consider that John Deere Capital (rated A2) just sold $350 million of a new 2-year FRN at LIBOR+50bps. Investors could buy a 1-year average life student loan bond and get more yield with less credit risk. Other alternatives, like agency discount notes, collateralized mortgage obligations (CMOs), or other ABS, either yield less or exhibit more credit risk.

Of course, student loan ABS has widened for a reason. General market liquidity is the primary reason. In consort with the lack of liquidity is the fact that funding of leveraged positions has become more difficult. So buyers who might have arbitraged away the wide spreads in student loans are just not able to do so. Indeed, there is no obvious catalyst for student loan ABS to tighten from current levels.

But these securities allow investors a place to hide from credit risk while still earning attractive interest rates. Eventually the fundamental value of these bonds will bring in buyers weary of losses in other sectors.


Aaron said...

Just a point. The Fed guarantee depends on the fulfillment of certain performance requirements by the servicer. While it's likely that SLM can carry these out, there's a chance that in the event Sallie goes under the new servicer will not have the same ability.

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