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Fixed-Income Insights

Commercial mortgage-backed securities are more diversified than recent headlines are suggesting.

Back in August 2009, The Wall Street Journal published an article titled, “Commercial Real Estate Lurks as Next Potential Mortgage Crisis.” The piece warned about a surge in foreclosures on commercial properties, the potential challenges property owners would face in refinancing loans, and, ultimately, the losses for investors in the commercial mortgage-backed securities (CMBS) market. Twelve months later, the representative benchmark, the Bank of America Merrill Lynch CMBS Index, had returned 22.5%.  From the date of the article through March 21, 2017, the index is up 61%.  

Fast forward to March 2017, and we again are faced with gloomy headlines for CMBS.

According to a recent Bloomberg feature, market speculators have identified ground zero for the next U.S. credit crisis: your local mall. Their thesis is that CMBS, some of which contain loans backed by shopping centers, stand to suffer if anchor tenants like Macy’s, Sears, and J.C. Penny fall behind on the rent.  

Will an evolving retail landscape affect certain corners of the CMBS market? In our view, the answer is most certainly yes. But here are three reasons why CMBS shouldn't be the next “big short.”  

1. CMBS is a diversified market.

 

Chart 1. Property Type Breakdown (as of December 1, 2016)

Source: Morningstar.

 

As noted in a recent Lord Abbett investment brief, the CMBS market is both large and diverse. Chart 1 shows that this roughly $1 trillion segment of the bond market is comprised of loans backed by a wide variety of income-producing properties, including retail stores, office space, residential buildings, hotels, industrial properties (including those providing e-commerce fulfillment), and even hospitals. 

While loans on retail properties represent the largest segment of the CMBS market (as measured by outstanding issuance), a typical CMBS deal combines loans backed by many different property types across a variety of regions.

2. Retail loans are not created equal.

We agree that traditional retailers face both secular and cyclical headwinds. On the secular front, consumers (millennials in particular) are increasingly shopping online and choosing to spend more on “experiences” rather than material goods. From a cyclical perspective, the stronger dollar has negatively affected tourism spending, while lower oil prices have weighed on discretionary outlays in certain regions of the United States.

But these are hardly new developments, and experienced CMBS investors have been well aware of the challenges facing traditional retailers for several years. Furthermore, retail properties backing loans in many CMBS deals cover a wide spectrum, from traditional malls to outlets to lifestyle centers (e.g., open-air retail spaces, often with high-end tenants). Even within the same subgroup, fundamentals can differ significantly. For example, there are critical differences between loans backed by malls that rely on aging big-box tenants in a location with moderate economic activity (like a struggling oil town) and those backed by shopping centers offering premium food and entertainment options in superior locales. Here’s another way to think about it: Higher-end (“Class A”) malls, with revenues from Apple stores, movie theaters, and high-end retailers may be thriving, while “Class B” or “Class C” malls in the same town can be facing bankruptcy. Factor in key financial considerations, such as the debt-servicing capabilities of specific tenants, and it’s clear that CMBS is an idiosyncratic market. For investment managers with expertise in commercial real estate and structured products, these nuances may represent opportunity where others only see risk.

3. CMBS deals have credit enhancements.

Many CMBS deals have features that may protect some investors from losing money in case a property doesn’t recoup the full amount of the loan. These features, also known as credit enhancements, allow investors to select specific tranches of a CMBS deal that best fit their objectives and tolerance for risk.

For example, a typical CMBS deal provides credit enhancement (i.e., subordination) of 30% on the super senior ‘AAA’ tranche. In other words, 30% of the underlying loans in the CMBS deal would have to default and offer no recovery value before investors in the ‘AAA’ tranche are subject to principal loss. Of course, there typically is some level of recovery value associated with defaults. Assuming a recovery value of fifty cents on the dollar, for example, a full 60% of the underlying loans would have to default before principal loss is incurred. 

To put these examples into context, consider the annual default rate for CMBS peaked at just over 4%, according to the National Real Estate Investor. In fact, few, if any, super senior CMBS bonds suffered credit losses throughout the financial crisis of 2008–09.

Tap into Our Expertise

At Lord Abbett, we believe that CMBS is an asset class that can continue to play a valuable role in a fixed-income portfolio, potentially providing investors with income and diversification benefits. It also is our view that successful, long-term CMBS investing requires specific research expertise.

From a research perspective, we analyze and stress test every CMBS deal in which we participate. Our approach begins with analysis of key deal statistics, including loan-to-value ratios, debt-service coverage ratios, geographic diversity, and property types. Our portfolio managers then collaborate with Lord Abbett’s global equity and credit research analysts to develop and maintain a dynamic understanding of specific companies and industries that affect the CMBS market. This deep understanding provides opportunities to identify value, exploit dislocations, and generate attractive risk-adjusted returns.

Lord Abbett also has been actively investing in CMBS for nearly 20 years, and with more than $10 billion in CMBS assets under management (as of December 31, 2016), we believe that our significant presence gives our clients an edge. We have strong relationships across a vast network of bond dealers and investors, providing access to off-market deals and the latest intelligence on market developments, expected issuance, and price signals. Looking ahead, we will continue to employ rigorous, bottom-up research to capitalize on inefficiencies and manage risk in this large and evolving market.

 

The credit quality of the securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO) such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities. High yielding, non-investment-grade bonds involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

The BofA Merrill Lynch US Fixed Rate CMBS Index tracks the performance of U.S. dollar-denominated investment-grade fixed-rate commercial mortgage backed securities publicly issued in the U.S. domestic market. Indexes are unmanaged, do not reflect the deduction of fees or expenses and expenses, and are not available for direct investment.

Source: Merrill Lynch and Pierce, Fenner & Smith Incorporated (“BofAML”), used with permission. BofAML permits use of the BofAML indexes and related data on an "as is" basis, makes no warranties regarding same, does not guarantee the suitability, quality, accuracy, timeliness, and/or completeness of the BofAML indexes or any data included in, related to, or derived therefrom, assumes no liability in connection with the use of the foregoing, and does not sponsor, endorse, or recommend Lord, Abbett & Co. LLC or any of its products or services.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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