Last year, as commercial-mortgage-backed securities rallied from the 2008 market collapse, investors pocketed returns of 17 to 40 percent or more on triple-A-rated CMBSs. “It was like shooting fish in a barrel,” one investor recalls.
Today that barrel looks empty. Returns have fallen to about 6 percent for triple-A commercial mortgage paper. Most CMBS investors are worried about a welter of problems: the European sovereign debt crisis, impending changes in financial regulation, the state of the U.S. economy and the prospect of more CMBS defaults.
“There’s a ton of uncertainty,” says Alan Todd, head of CMBS research at J.P. Morgan. “Many investors feel there are many potential outcomes [to the current troubles ] and that resolution may still be a few years away, so they are pricing for the worst — especially in light of the current price volatility.”
Who can blame them? Still, a handful of investors who are either foolhardy or possess exceptional foresight contend that the CMBS market represents an unusual opportunity. “CMBS is going to continue to be attractive relative to other products, including high-yield,” asserts Andrew Parower, a managing director of New York–based Marketfield Asset Management and the former head of CMBS at insurance behemoth American International Group. “There are opportunities deeper down the credit curve, but it’s going to be price- and deal-specific. There will be more bad news coming out, such as rising delinquencies, which is fine with me because we do our analysis anticipating that.” In December, Parower launched a Cayman Islands–based CMBS fund for Marketfield that caters to tax-exempt U.S. institutions and non-U.S. investors.
The CMBS bargains — if that’s what they turn out to be — can mostly be found on the lower rungs of the credit ladder. For instance, at the end of May, double-A ten-year paper was trading at 2,544 basis points over ten-year interest rate swaps. Dig even deeper to riskier triple-B-minus ten-year paper, and the spread mushrooms to 5,549 basis points, reports New York–based CMBS research firm Trepp. By contrast, triple-A CMBSs had a spread of just 228 basis points (compared with 783 in December 2008).
“Investors think these are going to get wiped out — it’s only a question of when — so they are priced at 5 to 15 cents on the dollar,” notes Trepp managing director Manus Clancy.
To avoid blowups, investors are scrutinizing credits extra closely. Howard Chin, who oversees a CMBS portfolio of about $1 billion for Guardian Life Insurance Co. of America, warns, “You have to do your due diligence and understand what’s backing the underlying loans.” Although he thinks forecasts of defaults and delinquencies have mostly been priced into the market, he acknowledges that it’s “debatable” whether all potential bad news has been taken into account. “We don’t agree with the levels that some bonds are trading at,” Chin says. “When we put some of them through our stress test, our default forecasts can be fairly different between bonds.”
To be sure, CMBSs are not exactly the comfort food of yield investing. In June, Trepp calculated that the delinquency rate of the mortgages making up CMBSs had jumped by 0.4 percentage point from April to May, to 8.42 percent. Fitch Ratings, meanwhile, said in May that through 2011, CMBS loss “severities” — the amount a loan has lost relative to its original balance — would outpace the annual average of 37.2 percent from 2002 through 2009. Mary MacNeill, a managing director in Fitch’s CMBS group, adds, “CMBS will continue to have more negative press, so while there’s a little more liquidity coming back to the market, we still see a lot more defaults and delinquent loans coming.”
Nevertheless, J.P. Morgan’s Todd argues that it’s only a matter of time before markets settle down and investors once again realize the upside potential of CMBSs. He believes the worst is already well behind the market and that investors can look forward to picking up more yield in the months ahead, without having to migrate down the credit ladder. “Although higher-rated CMBS spreads have already tightened significantly from their widest levels, we believe they have room to tighten further,” Todd says. “As markets have widened recently, we think this is a buying opportunity.”
