ABX index looks to find some of its old spark

During the recent meltdown of the US subprime mortgage market, the ABX derivatives index became a popular barometer of negative market sentiment. More lately it has had to fight a growing irrelevance but, with buyers at last starting to emerge for distressed mortgage securities, a new opportunity for the ABX is presenting itself.

Banks on Wednesday began trading a newly constructed addition to the ABX. This tracks the performance of a portfolio of subprime mortgage bonds and has risen rapidly in investor consciousness as a favoured way to bet on the subprime collapse.

The new sub-index will allow investors to bet on a recovery for the highest rated bonds, amid growing consensus that triple A subprime securities are underpriced. The so-called “penultimate triple A” sub-index will add a new, more senior, triple A slice to the existing five sub-indices.

Chris Flanagan, analyst at JPMorgan, says: “In much the same way that the indices highlighted over-pricing for triple B bonds at the outset they can now help highlight underpricing at the triple A level.”

Launched less than two years ago, the ABX became an important trading instrument for hedge funds and other investors betting that the riskiest triple B rated bonds would lose their value, amid record high late payments and defaults on subprime home loans.

Negative sentiment later seeped into the sub-indices for more senior triple A bonds. This was as conditions in the financial markets deteriorated and banks sought to hedge large portfolios of such bonds that they retained on their balance sheets.

Now, with subprime losses all but wiping out the triple B bonds, traders say liquidity has dried up for these trades. Interest is instead focused on trades for the most senior bonds in the capital structure, where investors are starting to believe there may be value.

Michael Boyle, ABX trader at UBS, says: “The fate of the triple B bonds is now a certain conclusion.

“There are no more bets to make there. But at the triple A level, there are pricing disagreements, and that creates trading opportunities.”

Dealers say the new “penultimate triple A” addition to the ABX is therefore an attempt both to reflect and promote trading liquidity in the cash bond market, by providing hedging opportunities and greater price transparency for such bonds.

Says Mr Boyle: “As liquidity has started to return to the cash market for subprime mortgage bonds, trading has been concentrated on these penultimate bonds in particular”.

The new sub-index is also a way to revive flagging trade volumes on the ABX when the launch of future series of the index is increasingly in doubt.

Until recently, a new series of the ABX index was launched twice a year, with each new series referencing bonds issued in the previous six months.

The next series of the ABX, the 08-1 index, was scheduled to launch in January but had to be postponed as financing for subprime mortgages dried up in the second half of 2007.

This meant not enough subprime mortgage-backed deals were eligible for inclusion in a new index. The launch is now scheduled for July 2008 but traders and analysts doubt the date is realistic.

Mr Flanagan says: “It’s not going to happen. There are no bonds and there won’t be any for at least a year, if not forever.”

Meanwhile, trading liquidity on existing series of the ABX has ebbed in recent weeks.

Traders say towards the end of the first quarter ABX trading desks were seeing daily volumes in the order of several billion dollars.

This was because banks were using the index to hedge their mortgage portfolios ahead of first quarter earnings.

Trading volumes have since dwindled to a few hundred million dollars a day.

Dealers hope the new slice of the index will help revive trading volumes as markets begin the long road to recovery.

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