Subordinated Auto Bonds Still Outperforming

The consumer ABS market got off to a strong start in January, with the auto sector once again leading the way. Benchmark issuers Ford Motor Credit and Santander Consumer USA kicked things off, but by the end of the month, nearly all of the auto industry’s sub-sectors, from retail auto loans and leases to rental cars, had been represented.

Nine publicly offered deals totaling $11.3 billion had priced as of Jan. 30, compared with five deals totaling $6.5 billion in for all of January 2012, according to ASR Scorecards.

Deals were heavily subscribed, even as spreads tightened, particularly among subordinated bonds. Take Ford’s $1.7 billion offering of three-year notes backed by dealer floorplan financing, which priced on

Jan. 17: The ‘AAA’ tranche priced at 38 basis points over LIBOR, a little wide of the 35 basis-point spread on the two-year, ‘AAA’ tranche of a deal priced in September 2012, but still inside the 47 basis-point spread on the two-year, ‘AAA’ tranche of a deal priced in February 2012, according to J.P. Morgan. (Ford didn’t issue any three-year floorplan ABS last year.)

By comparison, the ‘BBB’-rated three-year notes in Ford’s latest deal had a spread of 135 basis points, well inside the 170-basis-point spread on the two-year tranche priced in September 2012 and the 210-basis-point spread on the two-year tranche priced in February 2012.

Market participants say that, as shorter-dated, ‘AAA’-rated auto ABS continues to attract attention from nontraditional investors such as corporate treasurers, more seasoned ABS investors are broadening their horizons in search of incremental yield. This is fueling demand for longer-dated, lower-rated bonds.

Just 11 days into the year, J.P. Morgan revised its year-end targets for spreads. At 160 basis points, spreads on ‘BBB’ subprime auto ABS had already reached the firm’s target for mid-2013, for example. J.P. Morgan now expects its original year-end  target of 135 basis points to be reached in the first half of the year, and it has reset its year-end target for ‘BBB’ spreads at 135 basis points for subprime auto loans and 65 basis points for prime auto loans.

The firm has left its spread targets for benchmark ‘AAA’ auto ABS unchanged, however. “We originally predicted a rockier start to 2013, due to fiscal cliff uncertainty and expected high-quality, benchmark ABS as cash surrogates to lead the way,” analysts Amy Size and Kaustub Samant wrote in a Jan. 11 report.

That did not happen, and the analysts now expect that growing demand and tighter spreads for higher-yielding ABS will make issuers more willing to sell subordinated tranches, rather than hold on to them.

While subordinated bonds in general are benefiting from the reach for yield, bonds backed by subprime auto loans are getting an additional boost as investors become more comfortable with a change in the way these deals are structured. 

“It used to be the case that the subprime piece of the [auto] world offered some pretty rich spread, or compensatory spread for the risk, but spreads have narrowed significantly and they now offer relatively smaller pickups to prime auto paper, particularly in larger and more liquid names such as Americredit and Santander,” said David Canuel, a managing director and co-head of ABS and non-agency residential mortgages at Babson Capital Management.

Canuel, who is responsible for asset-backed strategy and analysis at the money manager, said that subprime auto ABS “had a little bit of a taint following the financial crisis, because historically the paper came on a wrapped basis and there was little or no subordination.”

When the bond insurers pro-viding this wrapper were downgraded, investors in the top-rated tranches were left with little protection, even though most of these tranches eventually did not suffer actual losses.

“Post-crisis, issuance structures came unwrapped, but with very substantial credit enhancement, both in terms of hard [enhancement] as well as typically a reserve fund and a very significant amount of excess interest,” Canuel said.

This excess interest is often enough to cover any losses that would be coming off the collateral, even in a stressed case. As a result, Canuel said, “the fixed-rate classes, particularly those with a one- and three-year average life, had a very significant amount of coverage.”

As the market has come to realize how much protection these classes have, investors have gradually bid subprime spreads closer and closer to spreads on prime auto paper.