Keep an eye on the tightening
It seems a long time since the European ABS market saw any meaningful volatility. The first quarter of 2016 was the last period of material turbulence, when at its height, fears of a global slowdown and questions over Deutche Bank’s capital position drove sentiment.
Despite a period of relative calm since, we would be the first to concede that while ABS has exhibited low volatility, it is by no means immune from it.
Over the last month, the fallout from the Italian political uncertainty has created a modicum of ABS volatility that is worth exploring.
That volatility has been most visible through the peripheral senior ABS sectors. At the eye of the storm, three-year BTPs soared from 0.15% to 2.80% before rallying on Friday to 0.87% (still a move of +72bp) while three-year Italian auto ABS saw a peak-to-trough weakness of just +20bp. Portugal has historically always been the bellwether for ABS volatility, or lack of it, in part due to the market’s small size and the relatively high extent to which dealers participate in the market, and this time was no exception. Benchmark seven-year RMBS were as much as +40bp wider, matched more closely to the +43bp seen in 10-year Portuguese government bonds during the same period.
One new development has been the number of willing sellers of ABS paper visible through bids-wanted-in-competition lists (BWICs) – an auction process mostly specific to the ABS market. Bonds on these lists have been heavily biased to peripheral names, in both senior and mezzanine paper. This is perhaps a reflection of the strong relative performance in ABS year to date.
CLO spreads have also been impacted, though interestingly in a fairly balanced move wider across BBB, BB and B of +15-20bp. We tend to expect CLOs to be the most correlated part of the ABS market to European high yield and euro AT1s, which have experienced spread moves of around +45bp and +100bp respectively. It is worth noting that continued primary supply in this sector had already put spreads on a softer footing.
One relative safe haven so far has been the UK, with AAA paper from specialist lender Together unchanged at around Libor+75bp, for example. Our own trading activity in mezzanine paper has also demonstrated healthy bid depth and consistent liquidity. UK ABS paper remains attractive on the basis of fundamental credit strength, but there is also a Brexit premium worth clipping in UK ABS and other UK fixed income assets.
At the tight spread levels brought on by ECB buying and a lack of primary supply, Italian and Portuguese RMBS spreads were probably always more susceptible to a sell-off, regardless of their proximity to the European political landscape. It would have made sense to reduce exposure to these sectors over the last 12 months given the strength of the preceding rally. We do believe volatility is more likely in these areas given the unresolved political situation and the wind-down of QE on the horizon, though deals from strong sponsors should prove more resilient.
The deeper we get into periods of market volatility, the harder it is for ABS performance to avoid some seepage from broader markets. This has been a gentle, timely reminder.