Commercial Mortgage-Backed Securities: Investors Latch On to New Issue
Dislocation between primary and secondary CMBS markets limits near-term upside.
This Commercial Mortgage-Backed Securities sector report is excerpted from the Third Quarter 2017 Fixed-Income Outlook.
Private label CMBS now represents only 10 percent of outstanding CRE finance, down from a peak of 23 percent in 2007 (see chart, top right). Fannie Mae and Freddie Mac have assumed a near-monopoly in multifamily finance, and the demand from banks and insurance companies has dramatically encroached on CMBS’s footprint. From a credit perspective, CMBS metrics are somewhat mixed in 2017, as first mortgage loan-to-value ratios (LTVs) have improved alongside greater concentrations in interest-only loans and increased mezzanine and B note financing. Recently, CMBS bonds have traded in secondary markets at significant discounts to new issue. Despite similar metrics and shorter tenors, CMBS secondary bonds are not finding the sponsorship of their new-issue counterparts.
While CMBS supply constraints have buttressed CMBS spread levels in the face of an 8 percent decline in CRE transaction volumes and ongoing retail challenges, the dislocation between primary and secondary markets is difficult to explain. Viewed in a positive light, the dislocation represents a buying opportunity for investors with sufficient resources and patience to navigate secondary markets, but may highlight liquidity concerns and a splintering buyer base at current new-issue spread levels. By contrast, large loan CMBS has had robust new issue supply and significant secondary demand. Year to date, $17.9 billion large loan transactions have been issued, compared to $8 billion last year. Primary and secondary market demand for these transactions has remained exceptionally high. In the secondary market, these transactions often trade at a premium, subjecting investors to a negative yield to worst. The risk of these securities being called and refinanced remains high in our estimation, and we have generally withdrawn from those secondary markets as a result.
Post-crisis CMBS, as measured by the Barclays U.S. CMBS 2.0 index, posted a positive total return of 1.4 percent for the second quarter. The AAA-rated and AA-rated tranches of the index returned 1.3 percent each, while A-rated and BBB-rated CMBS 2.0 tranches had stronger total returns of 1.7 and 2.6 percent, respectively.
Given the mixed market technicals, we have become more defensive. We generally prefer up-in-credit securities and have focused on secondary markets to the extent possible. We remain active in floating-rate large loan and CRE CLO transactions, and have limited our activity to primary markets where the purchase price is not at a premium and our investors are not exposed to negative yields in a call scenario.
Private Label CMBS Loses Market Share
Private label CMBS now represents only 10 percent of commercial and multi-family debt outstanding, down from its peak of 23 percent in 2007, while market share of Agency CMBS, as well as banks and insurance companies, has increased.
Source: Flow of Funds Accounts, Federal Reserve Board of Governors, Commercial Mortgage Alert, Guggenheim Investments. Data as of 12.31.2016. Note: The Federal Reserve changed its reporting for CMBS in Q2 2013, which resulted in a decrease in outstanding CMBS of about $130 billion that was recategorized as REIT debt.
New-Issue CMBS Spreads Tighten
CMBS supply constraints have buttressed CMBS spread levels in the face of a 12 percent decline in CRE transaction volumes and ongoing challenges for retail properties.
Source: Wells Fargo, Guggenheim Investments. Data as of 7.17.2017. New issue XA is a type of interest-only tranche.
—Peter Van Gelderen, Managing Director; Shannon Erdmann, Director; Simon Deery, Vice President
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