A revived CMBS (commercial mortgage-backed security) market, with new deals getting done, is helpful to REITs and other commercial real estate owners as it has started making financing available again. Spreads had generally been narrowing, which helped loan originators by reducing the hedging cost, and that has been good for owners of CMBS bonds. However, recent spread volatility has left some people concerned and wondering about the future direction of spreads and how to look at spreads on the new CMBS 2.0 deals in the context of 2006-7 legacy deals.
I always find it useful to start with views of market participants and historical data for some perspective. Also, for legacy deals, estimates of losses are an important element. Below are forecasts for spreads for 2007 vintage CMBS for June 2011 published by the industry’s weekly newsletter, Commercial Mortgage Alert, at the beginning of the year, along with some other data. Comments and thoughts follow.
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|Loss Estimates (%) by Market Participants|
S e t
|CMBX1 (2005)||CMBX2 (2006)||CMBX3 (Early 2007)||CMBX4 (Late 2007)||CMBX5 (Late 2007/ 2008)|
|Note: Loss estimates from market participants including sell-side research group, rating agencies, and advisory services. Periods for each CMBX series are approximate.|
Recent Spread History
|Spread Over Swaps|| |
|11 Feb 2011|| |
18 Mar 2011
1 Apr 2011
|Generic 2007 A4|| |
|GG10 A4|| |
|CMBS 2.0 AAA|| |
|Average Spread Over Treasury||2003||2004||2005|
|Corp - Generic A Rated Industrial||88||69||74|
Recent Spread Widening
To focus first on what had people worried most recently – widening of GG10 A4 bonds by 50 basis points from mid Feb to mid March, it is important to step back and look at the bigger picture. GG10 spreads are more visible because it is a benchmark deal and trades more frequently. As the table “Recent Spread History” shows, (i) spreads did widen out, but are generally back to where they were before widening, and (ii) even when they widened out, they were inside where they were at the beginning of the year.
Another factor to look at is where spreads are compared to market’s expectations. The table above shows average prediction for 2007 vintage A4 bonds to be 184 over swaps. Mid March wide was swaps plus 190 and the current spreads are swaps plus 165. Again, not as alarming when looked at in that context.
CMBS 2.0 Spreads
Spreads for new CMBS 2.0 deals widened out too, but not by as much. They went from 110 over swaps at the tight to 120 and are back to 110, compared to swaps plus 130 at the beginning of the year. Spreads did not widen much, but where could they go now? One perspective is looking at the history. The underwriting, leverage, and subordination in the new deals are comparable to what they generally used to be in 2003 to 2005. However, looking at spreads over swaps at that time will not be as helpful because of the impact of recent events in swap markets. A better approach will be to look at spreads over the risk-free rate, or the spread over treasury notes. In the 2003 to 2005 period, CMBS AAA bonds averaged around T+75, whereas generic single-A industrial corporates averaged T+77. Currently, new CMBS spreads are swap plus 110 or T+117 and single-A industrials are T+97. This back of the envelope analysis would suggest that new CMBS AAA spreads could tighten by 20 basis points from the current levels. The demand for bonds is there and there is not a big supply in the pipeline. So the technicals favor continued tightening.
CMBS 2.0 vs. Legacy CMBS
Legacy CMBS deals are a bit more complicated given the losses expected by market participants (see table above). In general, expectations of losses seem to average around 11.5% for 2006-8 deals. One simple way of looking at the deals would be to assume subordination remaining after expected losses. On that basis adjusted subordination for legacy A4 bonds goes from 30 to 18.5, which is similar to the subordination for AAA bonds in new deals. Subordination for legacy AM bonds with loss taken out goes from 20 to 9.5. That is roughly between single-A and BBB bonds in new deals.
This simplistic approach ignores several other factors that also come into play, but does the market see these as comparable? Market spreads for legacy AM bonds at swap plus 280 seem wider than 190 and 270 for new deal single-A and BBB bonds. Similarly, legacy A4 spreads at S+170 are much wider than S+105 for new issue AAA bonds. However, if you look at yields, legacy A4 is around 4.65, close to the 4.60 on new issue AAA. Similarly 5.80 yield on legacy AM bonds is between 5.42 and 6.22 on new issue single-A and BBB bonds.
Logical inference from above is that, in this yield-hungry world, the legacy bonds are generally in line with the new issue bonds in terms of yield, and legacy bonds should tighten along with new issue. The choice between them comes down to investors preference for stability, hedging, leverage, duration, etc.
The above would suggest that a general widening in legacy but not in new issue bond spreads, unaccompanied by any deal specific news, as happened recently, may be an opportunity to pick up some cheap bonds if you can do detailed deal analysis and are confident in ability to pick better deals.
Note: This article was originally published in Markets & Economy.
Disclosure: I am long PCM, NLY, NRF, NCT.