Bonds Backed by Student Loans Are at the Head of the Class

According to Merrill Lynch, one-year FFELP student loan ABS currently yield 65 basis points (bps) over three-month LIBOR. Three-year paper has a spread of 100bps, and five-year comes in at 125bps. These spreads had been relatively constant in the 0-15bps area for several years before widening rapidly last fall. So far in 2008, student loan ABS spreads have moved higher or lower with the tide of liquidity. Spreads peaked in March, tightened in April and May, and have recently widened to near March levels again.

In a fixed-income market where many securities are offering historically wide spreads, student loan ABS offer some unique advantages over other short-term alternatives. The structure is most similar to a corporate floating rate note (FRN), but of course the student loan paper has no substantial credit risk. Consider that John Deere Capital (rated A2) just sold $350 million of a new two-year FRN at LIBOR+50bps. Investors could buy a one-year average-life student loan bond and get more yield with less credit risk. Other alternatives, such as agency discount notes, collateralized mortgage obligations (CMOs), or other ABS either yield less or exhibit more credit risk.

Of course, the spreads for student loan ABS have widened for a reason. General market liquidity is the primary reason. In consort with the lack of liquidity is the fact that funding of leveraged positions has become more difficult. So buyers who might have arbitraged away the wide spreads in student loans are just not able to do so. Indeed, there is no obvious catalyst for student loan ABS to tighten from current levels.

But these securities allow investors a place to hide from credit risk while still earning attractive interest rates. Eventually the fundamental value of these bonds will bring in buyers weary of losses in other sectors.

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At the time of publication, Graff had no positions in the stocks mentioned, although positions may change at any time.

Tom Graff is a Managing Director of Cavanaugh Capital Management, a registered investment advisor in Baltimore Maryland. The opinions expressed here are Graff's own and in no way are the statements of Cavanaugh Capital Management, and may or may not reflect the strategies being pursued for clients of Cavanaugh Capital Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Graff appreciates your feedback; click here to send him an email.