Commercial Mortgage-Backed Securities: Defensive Play
Volatile market conditions call for a focus on loss-remote, amortizing bonds and CRE-CLO deals with proven sponsors.
The fourth quarter of 2018 provided a stark reminder of the precarious nature of the current market environment. Concern over global growth and the policy risks around trade and foreign policy led to a spike in volatility. Given the prevailing investment environment, and with the commercial real estate (CRE) recovery entering its ninth year, we continue to favor more defensive, loss-remote, principal-bearing bonds. We also favor senior interest-only bonds in conduit CMBS and both static and managed CRE-CLO investments with proven deal sponsors at spreads similar to or better than conduit spreads.
In 2018, conduit issuance dropped to $40.2 billion from the $47.4 billion issued in 2017 and the $47.6 billion issued in 2016. Despite this decline in conduit issuance, partly precipitated by the rise in issuance of CRE-CLOs, CMBS conduit remains the largest asset class in the private commercial real estate securitized market. CRE-CLO issuance had a record year in 2018, growing over 90 percent year over year. However, in 2019 the CRE-CLO market may struggle if investor demand for wide spreads on the liabilities persists. In late 2018, the spreads on the underlying loans did not widen as much as the spreads on the bonds, so issuing a CRE-CLO during that time did not make economic sense.
Conduit underwriting has remained relatively disciplined since the financial crisis, providing higher quality collateral pools. Average new-issue conduit underwritten loan-to-value (LTV) ratios rose 0.9 percentage point to 60.3 percent in 2018, but are down from 65.7 percent in 2014. Underwriters’ restraint regarding LTV ratios has largely been driven by investor preference, as issuers who have come to market with higher LTV conduit deals have suffered from softer demand and wider spreads. While some market skeptics fear the potential for manipulation of valuations in the underwriting process, there is no arguing that LTVs have decreased in recent years. Fitch Ratings Stressed LTVs can also be seen trending downward.
New Issuance Reflects Investor Preference for Lower Loan-to-Value Ratios
While some market skeptics fear the potential for manipulation of valuations in the underwriting process, LTVs have decreased in recent years. Fitch Ratings Stressed LTVs can also be seen trending downward.
Source: Guggenheim Investments, Fitch Ratings. Data as of 12.31.2018.
We also continue to favor seasoned conduit bonds to the extent they are available in the secondary market. These often trade at the same spread as new-issue bonds with less spread duration, especially at the junior AAA to single-A rating level. This, along with the flat swap curve, results in similar yields for the seasoned bonds. Additionally, the underlying properties in the collateral have enjoyed several years of significant price appreciation along with amortization of the loans, resulting in a decline in leverage.
New Issuance Reflects Investor Preference for Lower Loan-to-Value Ratios
We favor seasoned conduit bonds to the extent they are available in the secondary market. These often trade at the same spread as new-issue bonds with less spread duration, especially at the junior AAA to single-A rating level.
Source: Guggenheim Investments, J.P. Morgan Research. Data as of 2.8.2019. Secondary cash spreads are based on the J.P. Morgan cash spreads represented in CMBX 9 (2015 vintage conduit CMBS). These are JP Morgan estimates and may not reflect levels where we can obtain bonds. Minimum/maximum = 10.19.2018–2.8.2019.
—Shannon Erdmann, Director; Phil Hoehn, Vice President; Darragh Murphy, Vice President
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This article is distributed for informational purposes only and should not be considered as investing advice or a recommendation of any particular security, strategy or investment product. It contains opinions of the authors but not necessarily those of Guggenheim Partners or its subsidiaries. The authors’ opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is no guarantee of future results.
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