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The long and short of European CMBS

Despite growing volumes of ABS derivative trading in the US, repeated attempts to introduce index derivative products to more effectively express nuanced views on ABS credit spreads in Europe have had mixed results.

Now the developers of the latest rules-based ABS index – ECMBX, managed and calculated by Markit – argue that its concept and transparency will drive liquidity from day one. Moreover, they claim, both the underlying market and the intended clientele will be more receptive to a tradeable index offering than previous launches.

ECMBX comprises four sub-indices – sterling and euro triple-A and triple-B CMBS. Each sub-index will consist of 20 equally weighted names, which must have at least two ratings. Any bond less than six months old must have a factor of 0.9 or greater (where factor is equal to current face/original face) and any bond older than six months must have a factor of 0.75. Weighted average life in all cases must be between three and eight years and the notional triple-A references must have been at least €250 million or £250 million at issue.

The index rolls on a six-monthly basis and dealers, subject to a quorum, have the right to exclude deals. Markit then selects a replacement according to the index rules.

Similarly, ECMBX will benefit from being marked to market daily, and index prices will be generated by a price calculator hosted by Markit on its website – a move clearly intended to overcome investor shyness of proprietary pricing.

With international investment banks originating a rising volume of commercial mortgages for profitable refinance in the cash CMBS market, there is a clear need among these lenders for accurate credit risk management tools. At present, the only real hedge against widening cash spreads is a sophisticated yet general view of the future direction of spreads. Confronted by increased risks, these lenders should be early adopters of the new product.

Implied volatility

UK five-year CMBS spreads

Source: SG Credit research

Sameer Dalaman, European CMBS trader at conduit lender Deutsche Bank, argues that ECMBX meets this need. "The lack of CMBS spread hedges means that a bout of spread widening could cause profit erosion on loans that have already been originated," he says. "The immediate benefit of ECMBX to the banks will be greater certainty of profitability and thereby potentially the ability to underwrite loans at tighter pricing levels." In practice, this means conduit lenders shorting CMBX in anticipation of widening cash spreads in order to protect loans they have hard unwritten or acquired often years earlier.

Trading product

The risk management requirements of lenders notwithstanding, CMBX will fare better than its predecessors as a trading product, because CMBS spreads tend to be more volatile than the RMBS and consumer credit deals that a product such as ABS50 references.

This dynamic should ensure that the incentive to trade the index extends beyond Street dealing rooms to the broader investor community, argues Ian Willis of Lehman Brothers.

"Although it references the 50 most liquid ABS deals in the European market, clients haven’t bought into the rationale for ABS50," he says. "With triple-A spreads so stable at historically tight levels, they just didn’t see the need to hedge their long positions."

Subject to volatility trends, a possible index trading strategy could be a credit curve steepener – whereby the investor goes long the triple-A index while shorting the triple-B index. Dalamal offered a theoretical example. "With a steepener the client sells protection on the triple-A index at, for example, +12bp and buys protection on the triple-B index at +70bp, implying a current differential of 58bp. If this hypothetical curve were to steepen such that the triple-B widens out to +95bp and the triple-A tighten to +10bp – a net differential of 85bp, the investor will be able to capture that P&L."

Meanwhile, dealers argue, CMBX will be a natural complement to the new asset class of single-name CDS on triple-B CMBS tranches. "An index is the next natural step in the evolution of CMBS trading in Europe and can be usefully deployed alongside the single-name CDS. For example, an investor might go long the triple-B indices and buy protection on particular names in that index that he doesn’t like so much," Willis explains.

Relative value plays

Another possible approach concerns relative-value plays on European and sterling spreads where the investor goes long the euro triple-B index and short the sterling triple-B. Suffice it to say that increased spread volatility, which is historically more evident in the lower reaches of the CMBS capital structure, should lead to increased levels of directional trading.

Ironically, the appeal of this kind of strategy to sophisticated relative-value players might actually have the effect of increasing the volatility that real-money investors are trying to reduce.

"Relative-value players and fast money tend to use index strategies to extract short-term profits, and if there is a significant increase in the number of these trades using ECMBX, then this could well drive increased spread volatility. It’s a two-edged sword," concludes a third CMBS dealer.

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