Smaller Lending Companies Post Bigger Yields

A 3-month-old rally in the $700-billion asset-backed debt market has skipped many auto loan-backed bonds of smaller lenders, leaving them with higher yields than like-rated securities.

Investors willing to look beyond the securities of the giant auto lenders such as Ford Motor Credit are rubbing their hands over two-year, rated securities from smaller companies yielding about 5.75%, much higher than the benchmark U.S. Treasury notes.

Companies such as WFS Financial Inc. in Irvine, Union Acceptance Corp. in Indianapolis and Arcadia Financial Ltd. in Minneapolis are finding that even after buying insurance to make their securities “AAA� rated, they must offer higher yields than their bigger competitors. All three companies lend to consumers with less-than-sterling credit histories.

“I still think there’s pretty good value� in the securities of those companies, said Doug Kelly, who helps manage about $2.7 billion at Merganser Capital Management in Cambridge, Mass. Merganser, which takes its name from a duck that dives below the surface to catch fish, has “added all three names recently,� Kelly said.

WFS Financial’s stock has surged about 60% in the last week, apparently in response to a better-than-expected first quarter earnings report. On Monday, the shares rose 10.4%, or $1.25, to $13.25.

Asset-backed sales from the three companies and other “non-prime� auto lenders totaled $11.8 billion last year, down from $14 billion in 1997, according to Moody’s Investors Service. Market turmoil sparked by Russia’s August debt default widened yield spreads and kept some firms from selling securities last year.

Sales could rise to $14.5 billion this year as companies repackage more of their loans into securities, Moody’s said. WFS, for example, sat out the third quarter of 1998, preferring to hold more loans on its books. The company’s first-quarter 1999 sale, of $1 billion in February, was its biggest yet.

With the gap between prime and non-prime issues still wide, Rick Cipicchio, who helps manage $68 billion in fixed income at One Group Mutual Funds, said he expects to earn “the extra return of that tightening� as well as the securities’ interest payments.

Cipicchio said he’s recently bought bonds from WFS, UAC, Arcadia and Onyx Acceptance Corp. in Foothill Ranch.

The strong U.S. economy and more stringent lending standards among some non-prime issuers are helping boost investors’ confidence in the collateral backing the non-prime securities, analysts and investors said.

WFS, for example, said last week that auto loan losses for the first quarter fell one percentage point to 2.7% of average serviced contracts, compared with 3.7% in the year-earlier period.

While the possibility of bankruptcy in the smaller auto lenders is remote, it “is certainly more of a concern than with a Big 3 auto� company, Merganser’s Kelly said.

That’s one reason why Kelly and other investors said they consider only securities from smaller issues that are guaranteed by a financial insurer, such as Financial Security Assurance.

Even with the promise that interest and principal will be paid, the smaller-company issues carry higher yields because they are more difficult to trade, and because of the risk that if the lenders got into deep trouble their securities would weaken, despite the insurance.