Commercial Mortgage-Backed Securities: Same Risk, Less Reward

Negative net supply, insatiable demand, and risk retention requirements compress AAA/BBB spreads.

May 18, 2017


This Commercial Mortgage-Backed Securities sector report is excerpted from the Second Quarter 2017 Fixed-Income Outlook.

Commercial mortgage-backed securities (CMBS) rallied sharply during the first quarter, particularly in more subordinated tranches, owing to strong demand, negative net issuance of -$18.4 billion, and new risk retention structures. The clamor for risk assets and yield pushed historically conservative real money asset managers and insurance companies into more subordinated and riskier CMBS investments. The heightened demand from these traditionally more conservative investors compressed the spread differential between AAA and BBB tranches to post-crisis tights.

Spread Differential Between BBB and AAA CMBS Tranches

The heightened demand from traditionally more conservative investors compressed the spread differential between AAA and BBB tranches to post-crisis tights.

Spread Differential Between BBB and AAA CMBS Tranches

Source: Wells Fargo, Guggenheim Investments. Data as of 4.26.2017. Data shown are typical new issue spreads by tranche based on recently priced deals in 2017.

The heightened demand for subordinated CMBS securities, as well as for other parts of the capital stack, may be partially explained by the new risk retention requirements. The market believes that the “skin in the game” required by the new regulations results in a generally superior risk profile for the risk retention structures. Our analysis of these securities, however, has found that their credit quality is generally similar to 2015 and 2016 pre-risk retention transactions. In our view, “risk retention” is more of a marketing hook driving investor preference, as opposed to a fundamental credit improvement. We have also observed heightened risk tolerance in short-tenor, floating-rate large loan and commercial real estate collateralized loan obligations (CRE CLO) investment alternatives. In many cases these securities are trading at premium prices in the secondary market, despite being freely callable. The risk of these securities being called and refinanced remains high in our estimation, and as a result we have generally withdrawn from those secondary markets.

Post-crisis CMBS, as measured by the Barclays U.S. CMBS 2.0 Index, had a positive total return of 1.0 percent in the first quarter. Lower-quality tranches outperformed, with BBB-rated CMBS returning 3.0 percent versus 2.2, 1.1, and 0.8 percent for the A-rated, AA-rated, and AAA-rated tranches, respectively.

In such a strong market, we are locating relative-value opportunities in pre-risk retention transactions. There are many with similar or stronger credit metrics than their risk retention-compliant counterparts, and those pre-risk retention transactions trade at comparatively wider spreads and cheaper prices. We also remain active in floating-rate large loan and CRE CLO transactions, but 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.

Risk Retention Requirements Drive Wider Subordinated Pricing Discrepancy

The heightened demand for subordinated CMBS securities, as well as for other parts of the capital stack, may be partially explained by the new risk retention requirements. Our research shows the credit quality of pre-risk retention securities is generally similar to risk retention structures.

Risk Retention Requirements Drive Wider Subordinated Pricing Discrepancy

Source: Wells Fargo, Guggenheim Investments. Data as of 4.26.2017. Senior AAA is also referred to as last cash flow, or LCF.

—Peter Van Gelderen, Managing Director; Shannon Erdmann, Director; Simon Deery, Vice President

 
Important Notices and Disclosures

This article is distributed for informational purposes only and should not be considered as investing advice or a recommendation of any particular security, strategy or investment product. It contains opinions of the authors but not necessarily those of Guggenheim Partners or its subsidiaries. The authors’ opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is no guarantee of future results.

Investing involves risk. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-backed securities, may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity risk. Investments in floating rate senior secured syndicated bank loans and other floating rate securities involve special types of risks, including credit risk, interest rate risk, liquidity risk and prepayment risk. Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Real Estate, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management. ©2017, Guggenheim Partners, LLC. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC.


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