Earning investment income today is tough—and it’s probably going to stay that way. But there are opportunities in less traveled parts of the bond market. And they’re not as risky as you might think.
Consider US commercial mortgage-backed securities (CMBS). CMBS package together hundreds of loans for properties such as downtown office buildings, hotels, shopping malls and multifamily apartment complexes.
Like all securitized assets tied to US real estate, these bonds often get a bad rap. That’s understandable—but not entirely fair.
During the financial crisis, the plunge in the value of many mortgage-backed bonds was traumatic for investors. Holders of the lower-rated or equity tranches sustained big losses. To be fair, that’s the way structured products are supposed to work. The highest-quality tranches enjoy the most credit protection, while the lower ones offer higher yields but are first to absorb losses when underlying loans default.
NOT LAST DECADE’S LOANS
But the commercial loans originated after the CMBS market hit bottom in 2010 are very different from those that were made between 2006 and 2008. That’s because large and regional US banks got stricter and overhauled their lending practices. At the same time, credit enhancement levels for the non-AAA-rated CMBS have approximately doubled, which creates a deeper cushion against loan losses.
As the display below illustrates, the loan-to-value (LTV) ratios, which compare the size of the loan to the value of the property, came down sharply between 2010 and 2014. At the same time, property values rose, making the effective LTVs of these loan pools even lower. For instance, the BBB-rated tranche of CMBS issued between 2012 and 2014 offer strong credit fundamentals and yields of up to 7.5%.
Interestingly, CMBS issued in 2015 and 2016 are less compelling. While the top-rated tranches look fine, the BBB-rated ones don’t perform as well under stress scenarios, making them less attractive from a risk/reward point of view. This is mainly because we’re in the later stages of the commercial real estate cycle today—and it underscores the importance of being selective.
There are other features to US CMBS that we think make them attractive. They include:
- Stable earnings: The bonds are backed by earnings generated by contractual leases, so the cash flow they produce is stable. The longer the lease term, the better. And unlike in the UK and Europe, US leases don’t reprice until the term is up. So even if rents decline, the rate at the time of the contract is locked in.
- Static loan pools: In Europe, originators can substitute loans by refinancing the senior or junior slices of the structure. In the US, whatever was included at the start stays there. The loan pools are diversified, both by borrower type and geographically.
BUBBLE? WE DON’T THINK SO
Overall, the US CMBS market is now about 15% above its 2007 precrisis peak. That may sound alarming, but it isn’t. US stocks, by comparison, are up 37% from their precrisis peak. The CMBS increase has barely kept pace with inflation.
And while CMBS prices have rebounded, there has been no accompanying surge in supply. We think that means price declines should remain modest.
There are pockets of the market that have been overbid, and we think Federal Reserve Chair Janet Yellen has been right to point this out. Fortunately, the Fed and other US regulators have taken steps that should introduce even more discipline to the underwriting process.
BETTER REGULATIONS, BETTER UNDERWRITING
One of these steps involves using regulatory capital charges to impose discipline on US regional banks. The loans these banks are now writing come with origination LTVs of about 60%. In the past, their lending standards were looser, with LTVs of 65%. This more disciplined lending is important because regional banks’ share of the commercial real estate market has been increasing.
Another new rule will require CMBS issuers to retain 5% of every deal for five years. This ensures they have skin in the game because it prohibits them from turning around and selling the riskiest tranches that are first in line to absorb losses. These “risk retention” requirements were mandated by the Dodd-Frank act and will go into effect in December.
Could overall valuations dip from here? Sure. Tighter regulations and overall market volatility could contribute to that. But in our view, investors in higher-quality 2012–2014 CMBS should be reasonably well protected against stress losses.
Meanwhile, we think that the relatively stable US job market and a still-growing US economy should provide additional support. In fact, a modest market decline may present an attractive buying opportunity for careful investors.
It’s hard enough earning income these days without limiting yourself to just one or two pockets of the bond market. In our view, investors who diversify their portfolios to include promising sectors such as US CMBS give themselves a better chance to boost returns.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.