By the Numbers

Trading ABS against the corporate debt of the same sponsor

| March 31, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Wider spreads in ABS and an inverted yield curve make a compelling case for trading out of short investment grade corporate credit into senior amortizing ABS. The ABS adds both projected income and price return as the corporate debt rolls up the curve. And the projected ABS return advantage looks strong enough to survive significant shifts in interest rates.

An inverted yield curve makes a relatively good home for short, amortizing assets. Amortization across a wider principal window rolls along a yield curve more slowly than the interest-only, bulleted repayment structure frequently used by corporate issuers. In an inverted yield curve, all else equal, the ABS price should drop more slowly than the corporate. And return of principal in an inverted curve allows more frequent reinvestment at higher rates.

Removing the curve mechanics from the equation momentarily, ABS value relative to corporate credit on a curve-adjusted basis also shows up in the OAS ratio between the Barclays ABS and Intermediate Corporate indices. Looking back across a 10-year history, the OAS ratio between the two indices has averaged just over 50% with a standard deviation of about 10 bp, meaning that the average corporate index OAS has been roughly two times wider than the ABS index (Exhibit 1). Bearing in mind the significant credit quality differences between the two indices, it may be intuitive that market dislocations of pronounced magnitude, such as those observed in 2020, are often short-lived. That said, for periods when this ratio drifts more than a standard deviation higher, as it has recently, it presents interesting opportunity for exploring sector rotations from corporate credit into ABS.

Exhibit 1: Ratio of ABS index OAS to investment grade corporate index OAS

Source: Bloomberg, Santander US Capital Markets

A few comparisons to help frame the ABS relative value thesis:

Equipment ABS compared to the sponsor’s corporate debt:

Deere’s recently issued equipment ABS transaction, JDOT 2022-C A3, is a ‘AAA’ class with a projected 2.1-year weighted average life and a yield of 4.88%. The clearest corporate comparison is the 3-year, ‘A’-rated DE 1.05% 6/26 senior unsecured bonds yielding 4.46%. Using the same sponsor holds the credit risk of the shared sponsor constant. Comparing projected returns on each ABS to those for a blended, dollar-duration matched portfolio of corporate and Treasury debt holds interest rate risk constant. That duration- and proceed-neutral comparison shows that under the base case, Deere’s ABS note delivers 23 bp of 1-year excess return and outperforms the unsecured debt in each of six parallel curve shift scenarios (Exhibit 2). Conducting the same analysis for HP and Dell, the selected equipment ABS bond produces a consistent return advantage over its unsecured counterpart.

Exhibit 2: Projected equipment ABS returns top corporate debt of the same sponsor

Note: All returns assume a linear parallel shift in the yield curve to a 1-year horizon, reinvestment as T-bills and horizon repricing at constant OAS. All market levels as of COB 3/29/23.
Source: Yield Book, Santander US Capital Markets.

Auto ABS compared to the sponsor’s corporate debt:

Using the same analytical framework to examine auto loan ABS, Honda has a significant footprint in both the term-ABS and unsecured corporate credit market. Assuming constant spreads over our 1-year horizon, our Honda ABS bond, HAROT 2023-1 A3, outperforms its unsecured corporate counterpart by an average of 10 bp across rate shifts of 100 bp (Exhibit 3).

Exhibit 3: Projected returns on Honda ABS tops its corporate debt

Note: projected returns assume linear parallel shifts in the yield curve to the horizon, repricing at constant OAS and reinvestment at forward 1-month Treasury bill rates. All market levels as of 3/28/23.
Source: Yield Book, Santander US Capital Markets.

Selection criteria

The issuers used in this analysis have a presence in both unsecured and ABS markets, allowing a swap that maintains constant exposure to the same ultimate parent company. The programs also have strong, establish secondary liquidity to minimize the possibility for idiosyncratic price volatility impacting the analysis. John Deere, HP, and Dell represented 37% of primary activity in equipment ABS last year, each pricing two or three deals sized between $500 million and $1.3 billion. Honda, a frequent issuer of prime auto loan ABS as well as unsecured corporate debt, historically is one of the tightest-trading, most liquid names in that universe.

Summary

For each swap outlined above, the results reinforce the notion that amortizing ABS should benefit from the current curve environment more meaningfully than interest-only structures. Under nearly all scenarios, ABS outperforms its unsecured corporate-and-Treasury benchmark over a 12-month horizon at constant spreads, while also improving the overall credit quality of the selected portfolio from mid-BBB/low-A to AAA.

For investors looking for low-duration trade strategies with an up-in-quality bias, look at sponsors with a footprint in both the securitized and unsecured market. Over the near term, amortizing ABS structures have better relative value than the unsecured counterparts of similar maturity. And current pricing offers a good entry point.

Jason Delanty
jason.delanty@santander.us
1 (646) 776-7873

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

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