Abstract Art and
ABS-Tracked Credit
Howard Cunningham
14 March 2008
No.44
Credit strategy: Overweight investment-grade
We were going to write a piece entitled "Why are we here?", reflecting on how credit got into such a mess, and on the raison d'etre of the monolines and rating agencies, so we turned to sometime existentialist, and sometime goalkeeper, Albert Camus for inspiration. We decided existentialism was too difficult. Instead, we found a quotation by Camus on abstract art that seemed wholly appropriate for certain parts of structured credit (eg CPDO, CDO of ABS, CDO-squared):
"Abstract Art: A product of the untalented, sold by the unprincipled to the utterly bewildered".
Perhaps the difference is that we doubt anyone ever had the gall to try to sell you a "Jackson Pollock-squared".
What is ailing the credit markets most at the moment is largely a (dys-) function of structured credit markets:
- First, through the wonders of RMBS, unscrupulous, reckless or complacent brokers and lenders were able to originate and package up sub-prime and low-quality home equity mortgages and sell on the risk to insouciant, yield-hungry investors.
- Rating agencies were persuaded to assign investment-grade ratings to vast swathes of this sub-prime mortgage debt, with maybe 70% rated AAA. This was because "expected losses" on the most senior tranches were very low. What the "untalented" and "unprincipled" didn't make clear to the "utterly bewildered" was that, if losses were "unexpectedly" higher, the impact on their securities could be catastrophic.
- To add an extra layer of comfort (and fees) to the structure, monoline insurers guaranteed the highest rated tranches (resulting in a "AAA guarantee of a AAA security".
- Then certain investors (including banks and brokers, hedge funds and SIVs) engineered even higher yields by leveraging AAA and other highly-rated securities. Apply 20x leverage to a highly rated security, giving you, say, LIBOR +50b.p., and you can earn a return of LIBOR +10%. And why not? AAA securities never default and house prices never go down!
- Now the cat is out of the bag, overstretched low income home-owners are defaulting on their mortgage payments, and what were low investment-grade securities are now rated as junk, and even the AAA securities are sliding down the investment-grade spectrum. Meanwhile, as funds are needed to cover losses or to raise cash for redemptions or because of margin calls, investors are having to sell what they CAN - i.e. high-quality corporate bonds not exposed to sub-prime borrowers, and this is having a detrimental impact on prices. This is also leading to "unwind triggers" being hit on "market value" structures, re-enforcing the vicious circle of selling and price falls.
- This is leading to some unusual price relationships, with those "low-default" segments most used in leveraged/structured credit under-performing some higher-risk assets.
Our message would be that just because you don't like abstract art, there is no need to burn your old masters. In the same way, there is no need to ditch plain vanilla investment-grade corporate bonds. And, unlike an unfashionable work of art, in the period until its intrinsic value is appreciated again, the coupon on a corporate bond will at least pay the bills. Although much of the credit markets are as shambolic as Tracey Emin's bed ("My Bed" 1999, Turner Prize shortlist), there is lots of intrinsic value for unleveraged buy-and-hold investors to exploit. We have written before about the relative value of major banks versus corporates, but we acknowledge that banks are at the centre of the deleveraging storm. Now that non-financial corporate bonds (as well as bank bonds) have repriced, there appears to be value in non-financial investment-grade corporate bonds.
Newton Capital Management Limited
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