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Fixed-Income Insights

Commercial mortgage-backed securities (CMBS) have a role to play in conjunction with corporates, both as a diversifier and on their own merits as an asset class.

 

In Brief:

  • CMBS have offered comparable and, in some cases, meaningfully wider spreads versus corporates at little to no incremental principal risk.
  • Underwriting standards for CMBS have improved substantially from the pre-financial crisis environment.
  • Idiosyncratic opportunities may exist for an active manager with deep research capabilities

 

As the expansionary phase of the current U.S. credit cycle continues to show few signs of  ending anytime soon, we’ve heard various voices and read many articles suggesting that, at this point in the cycle, perhaps  the investment-grade corporate bond market, with its large concentration in ‘BBB’-rated issues, is an area of concern. We understand this concern, although we do not agree with it

Nevertheless, for investors who are looking for alternative investment-grade opportunities, we believe that commercial mortgage-backed securities (CMBS) are one such asset class to consider. CMBS can potentially play a role in conjunction with corporates, both as a diversifier to the aforementioned concerns and on their own merits as an asset class.

In this article, we focus on non-agency1 CMBS, which, according to Intex Solutions, accounts for just $525 billion of the overall $4.3 trillion commercial real estate market, as reported by the U.S. Federal Reserve,  and is dwarfed by the $8 trillion corporate bond asset class. Nevertheless, non-agency CMBS  enjoy a deep market with over 260 trading participants.  

While not enjoying a market-size advantage over corporates, CMBS do hold meaningful advantages in terms of structure. In contrast to corporate issues where companies “levering up” (i.e., issuing bonds) is always a risk, CMBS de-lever over time. Many have an amortizing feature, with cash flows growing through the life of the loan, resulting in lower leverage over time. Additionally, CMBS are backed by real property – the real estate each loan is made to fund – while corporate debt generally is unsecured. With a waterfall 2 repayment system (having to do with structural protection and payment priority) typical of many structured products, CMBS can also offer the potential for meaningful structural protection, depending on the tranche owned.

Past Versus Present
Prior to the global financial crisis (GFC) of 2008-09, CMBS traded “in line” with corporate debt on a rating-to-rating basis, but since the crisis that has changed. Corporates now regularly trade tighter (i.e., with narrower spreads) than comparably rated CMBS debt. There are several possible causes for this, relative size being one. Prior to 2008, CMBS made up about 5% of the then-Lehman Brothers Aggregate Bond Index, now the Bloomberg Barclays Aggregate Bond Index, with corporates at 17%. Those numbers today are closer to 1.5% and 28%, respectively. Volatility may also be a driver, with CMBS, generally speaking, exhibiting higher trading volatility compared with corporates. The effort needed to analyze a comparatively small market may also contribute; market participants may be unwilling or unable to commit the resources needed to effectively invest in the asset class, instead expending resources on larger markets.

Whatever the cause, this has led to CMBS offering comparable and in some cases meaningfully wider spreads compared with comparably rated corporates, offering an attractive opportunity to generate alpha, in our opinion.

 

Chart 1. Before and After the GFC, AAA-Rated CMBS Have Traded In Line With Lower Rated Corporate Debt
Asset swap spreads of corporate bonds and fixed-rate CMBS (January 2000–January 2018)
Source: ICE Bank of America Merrill Lynch. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Bp=basis points. GFC=Global Financial Crisis 2008-09. The Asset Swap Spread is the difference between the yield of a bond and the Libor curve expressed in basis points and is designed to show the credit risk associated with a bond.

 

Chart 2.  Since the GFC, BBB-Rated CMBS Have Been Trading at Meaningfully Wider Spreads Compared With Similarly Rated Corporates. 
Asset swap spreads of corporate bonds and fixed-rate CMBS (January 2000–January 2018)

Source: ICE Bank of America Merrill Lynch. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Bp=basis points. GFC=Global Financial Crisis 2008-09. The Asset Swap Spread is the difference between the yield of a bond and the Libor curve expressed in basis points and is designed to show the credit risk associated with a bond.

 

Underwriting standards for CMBS have actually improved substantially from the pre-crisis environment, where loan-to-value ratios (LTV) were typically in the high 60’s to low 70’s. These numbers perhaps understate the issue, given the amount of pro forma underwriting occurring at the time. When that is taken into consideration, in our view the real LTV would have been 80% or even higher.

 

Chart 3. CMBS Underwriting Standards Have Improved Substantially Since the GFC
LTV exposure by loan balance, weighted average (2005-2019)

Source: ICE Bank of America Merrill Lynch. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. LTV=Loan-To-Value Ratio. W.A.=Weighted Average. GFC=Global Financial Crisis 2008-09.

 

Additionally, structure has gotten meaningfully stronger since 2008. In the period prior, BBB- CMBS had 3% credit enhancement, and perhaps less. Today, credit enhancement for BBB- tranches typically runs 5.75-9%. And while a 12% enhancement garnered a AAA rating in 2007, today that tranche would run in the A-/BBB+ range.

 

Table 1. The Structure of CMBS Has Gotten Stronger Since the GFC
Typical conduit structures (2007 versus 2019)

Source: ICE Bank of America Merrill Lynch.  For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. GFC=Global Financial Crisis 2008-09. Conduit=Tranch

 

Over the same period, corporate leverage has increased meaningfully and debt service ratios have dropped. When compared to CMBS, the divergence is rather stark.

 

Chart 4.  CMBS Leverage Has Declined Versus Corporates
Turns of leverage for corporate bonds versus CMBS (1999-2018)

Source: ICE Bank of America Merrill Lynch.  For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. CRE=Commercial Real Estate. HG=High Grade. Turn of Leverage=debt to EBITDA leverage ratio.

 

Chart 5. Corporate Debt Service Ratios Have Declined While Those of CMBS Have Improved
Debt service ratios for corporate bonds versus CMBS (1999-2018)

Source:  ICE Bank of America Merrill Lynch. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.  DSCR=Debt Service Coverage Ratio.  LTM=Last Twelve Months. EBITDA=Earnings Before Interest, Taxes, Depreciation, and Amortization. HG=High Grade.

 

Conclusion
In our opinion, these factors, at an asset-class level, argue for the inclusion of CMBS across portfolios with differing overall risk targets, both investment and non-investment grade with differing liquidity needs. When paired with in-depth valuation and credit work on a bond-by-bond basis, the dual sources of possible alpha, both allocation and selection, make the case more compelling still.

(For Additional information on CMBS, please see Lord Abbett Investment Brief: Commercial Mortgage-Backed Securities (CMBS).)

 

1Agency CMBS are mortgage bonds issued by Fannie Mae, Freddie Mac, or Ginnie Mae -- the government-supported agencies that guarantee mortgages. Non-agency CMBS (also referred to as "private label" CMBS refer to securities that are made up of loans that are not guaranteed by one of these agencies.

2waterfall structure is a repayment system by which senior lenders receive principal and interest payments from a borrower first, and subordinate lenders receive principal and interest payments after. A bond spread is the difference in the yield between two bonds.  

 

Glossary of Terms

A credit cycle describes the phases of access to credit by borrowers. Periods in which funds are relatively easy to borrow are known as expansionary phases and are characterized by lower interest rates, lowered lending requirements, and an increase in the amount of available credit, which stimulates a general expansion of economic activity. These periods are followed by a contraction in the availability of funds.

The DSCR or debt service coverage ratio is the relationship of a property's annual net operating income (NOI) to its annual mortgage debt service (principal and interest payments).

Last Twelve Months (LTMEBITDA is a valuation metric that shows earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) adjustments for the past 12-months period.

Leverage is the ratio of a company’s loan capital (debt) to the value of its common stock (equity).

Loan-to-value (LTV) ratio is an assessment of lending risk that financial institutions and other lenders examine before approving a mortgage. Typically, assessments with high LTV ratios are higher risk and, therefore, if the mortgage is approved, the loan costs the borrower more.

Weighted Average is an average resulting from the multiplication of each component by a factor reflecting its importance.

Alpha is the excess return of an investment relative to the return of a benchmark index.

Basis Point is one-hundredth of one percent.

The London Interbank Offered Rate (LIBOR) is a benchmark interest rate at which major global banks lend to one another in the international interbank market for short-term loans.

A turn of leverage or a turn of debt is a ratio that compares financial borrowings and the income needed to service it without taking into consideration interest, taxes, depreciation and amortization.

Pro-forma refers to a method by which firms calculate financial results using certain projections or presumptions.

The ICE BofAML US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market.  Subsets of this index include the ICE BofAML 7-10 Year AA US Corporate Index and the ICE BofAML 7-10 Year BBB US Corporate Index, which reflect specific maturities and credit ratings.

The ICE BofAML U.S. Fixed Rate Commercial Mortgage Backed Securities Index tracks the performance of U.S. dollar-denominated 30-year, 15-year, and balloon pass-through fixed-rate commercial mortgage securities having at least $150 million outstanding per generic production year.  Subsets of this index include the ICE BofAML 7-10 Year US Fixed Rate CMBS Index and the ICE BofAML 7-10 Year BBB US Fixed Rate CMBS Index, which reflect specific maturities and credit ratings.

The credit quality of securities 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.

Source:  ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofAML INDICES 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 ICE BofAML INDICES 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.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

IMPORTANT INFORMATION

The information provided here is for general informational purposes only. It does not constitute a recommendation nor investment advice, and should not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable.

A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated bonds may be subject to greater risk than higher-rated bonds. No investing strategy can overcome all market volatility or guarantee future results.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

Diversification does not guarantee a profit or protect against loss in declining markets.

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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