Commercial Mortgage-Backed Securities: Watching Structural Developments
Full-term interest-only loans and higher debt service coverage ratios support AAA-rated interest-only bonds.
This Commercial Mortgage-Backed Securities sector report is excerpted from the Third Quarter 2018 Fixed-Income Outlook.
Private-label CMBS new issuance rose by 21 percent in the first half of 2018 over the same period last year, primarily driven by single asset, single borrower (SASB) issuance, which is up 62 percent. Conduit CMBS issuance is down 4 percent over last year due to a lack of available loans to finance, so competition remains high. A tactic conduit lenders are using to win loans is to provide full-term interest-only (IO) loans. Loans with full-term IO now represent 50.6 percent of the conduit collateral pool, compared to 19.2 percent in 2014. Correspondingly, the debt service coverage ratio (DSCR) has increased to 2.08x in 2018 from 1.73x in 2014. Both structural developments are beneficial to AAA-rated IO bonds. These bonds receive the excess interest of loans in the collateral pool over the weighted-average coupon of the AAA-rated principal-bearing bonds in the conduit, so long as the AAA-rated principal-bearing bonds remain outstanding.
Underwriting standards for conduit loans have remained surprisingly disciplined for this late in the cycle. The weighted-average loan to value (LTV) of 2018 conduit pools is currently 58.4 percent, up only around 1 percent from 2017, and the weighted-average debt yield is currently at 11.4 percent, only 40 basis points lower than in 2017. However, we have seen more deterioration in other credit metrics, such as total single tenant exposure and the LTV and DSCR associated with IO loans. But even with this deterioration, overall credit metrics still look healthy compared to the 2014/2015 levels.
Post-crisis CMBS, as measured by the Barclays U.S. CMBS 2.0 index, posted a gain of 0.1 percent for the second quarter. The senior-most AAA-rated and AA-rated tranches lost 0.02 percent and 0.03 percent, respectively, while A-rated and BBB-rated tranches gained 0.28 percent and 1.77 percent, respectively.
A structural development that has dominated floating-rate SASB this year is the two-year initial term bond with five one-year extension options vs. three one-year extension options. The former will fare worse in market selloff as they will trade assuming the loan will be extended to seven years. These bonds have limited upside because when the underlying loan prepays, the prepayment penalty paid on the loan is usually allocated away from the principal-bearing bonds to the interest-only tranche. We continue to favor more defensive, loss-remote, principal-bearing bonds along with senior IO bonds in conduit CMBS, and CRE CLO investments at spreads similar to or better than conduit.
Overall Credit Metrics Appear Favorable
Conduit Credit Metrics
We have seen more deterioration in credit metrics such as total single tenant exposure, and the LTV and DSCR associated with IO loans. But even with this deterioration, overall credit metrics still look healthy compared to the 2014/2015 levels.
Source: Morgan Stanley, Guggenheim Investments. Data as of 6.30.2018. IO = interest-only loans. WALTV = weighted average loan to value. WANCF = weighted average net cash flow. DSCR = debt service coverage ratio.
Riskier SASB Dominates New Issuance
Floating Rate SASB Issuance by Structure Type
Bonds with a two-year initial term with five one-year extension options will fare worse in market selloff as they will trade assuming the loan will be extended to seven years. These bonds have limited upside in prepayment scenarios as the prepayment penalty is usually allocated away from the principal bearing bonds.
Source: Morgan Stanley, Guggenheim Investments. Data as of 6.30.2018.
—Shannon Erdmann, Director; Darragh Murphy, Vice President
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