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A safe harbor in REITs amidst ‘BBB’ concerns
admin | May 31, 2019
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
Concern about the ballooning size of the ‘BBB’ market and mounting systemic leverage among issuers has resurfaced repeatedly since corporate issuance started a relatively unimpeded tear in 2012. Recent fresh concerns about credit coincided with a reversal in high grade bond fund flows last week, which broke a 16-week streak of in-flows. Lipper recently reported that IG funds saw a $5.1 billion outflow – the largest single weekly reading since 2015. Amidst the general concern about ‘BBB’, there may be safer harbor in REITs.
Shifting spread compensation for ‘BBB’
The additional spread compensation available in ‘BBB’ over ‘A’ corporates is currently in the low 60 bp range compared to a cycle low closer to 40 bp (Exhibit 1). The pick-up available compared to ‘AA’ credit is closer to 90 bp, compared with a recent cycle low of about 60 bp touched in early 2018. On a longer-term basis the current spread levels are on the lower-end of the spectrum. But as recent market concerns have highlighted, ‘BBB’ now accounts for a much larger portion of the exceedingly larger IG USD corporate bond market, which would suggest that investors globally are being given little choice but to allocate a greater portion of holdings to lower-rated credit based on supply trends.
Exhibit 1: ‘BBB’ has widened recently to ‘A’ and ‘AA’
Source: Bloomberg Barclays US Corporate Indices
Possible safer harbor in REITs
As markets appear to be reaching an inflection point, IG investors are faced with the decision of whether to pare back their riskier holdings, or ride out what could be a more volatile road ahead, at least in the immediate term. One area we would highlight within this ‘BBB’ dilemma is REITs. Because of their structure and common use of higher leverage, operators within the REIT industry have traditionally managed their balance sheets to ‘BBB’ credit quality (mostly). This differs from other segments within the IG index, which have only more recently seen a ramp up in debt issuance and more constituents in the lower rating categories.
REITs have mostly market-performed YTD, producing excess returns of 2.61%, directly in line with 2.59% for the Broad Corporate Index as credit mostly improved throughout the first four months of the year. Comparatively, during the last back-up in credit, beginning the first week of October 2018 and peaking in early January, the IG Index blew out over 50 bp in relatively short order. During the sell-off, the REIT subgroup gave up just 1.74% in excess return compared with a loss of 3.38% for the Index, and double-digit weakness in some of the more sensitive credits within IG. In short, the sector has demonstrated greater stability during recent periods of market turbulence, despite a high concentration of ‘BBB’ issuers within the industry. Investors proved more comfortable carrying these risks versus other more cyclical industries.
Trade Idea in REITS: Corporate Office Properties (OFC) 2025s
OFC’s 2025 bonds (rated Baa3/BBB-) are offering value in this part of the curve over comps. The OFC 25s trade right on top of its closest office REIT peer comp, CXP 4.15 ‘25s. Though CXP is technically higher-rated at Baa2/BBB, the relative risk profiles between the two credits is perceived to be closer due to OFC’s more stable, primarily government and government-related tenant base, as well as its moderately larger size. Office REITs have performed relatively well year-to-date as suggested in the time series graph of the industry’s spread curve (Exhibit 2) – the one exception being OPI bonds, which are the levered outcome of the merger between GOV and SIR that closed earlier this year (combined rating Baa3/BBB-). The suburban office segment has been challenged over the past several years, amidst overcapacity in properties and higher occupancies. OFC’s higher occupancy and retention rates stand out over its closer peers.
Exhibit 2: OFC 25s vs BBB office REIT comps
Source: Amherst Pierpont Securities, Bloomberg/TRACE G-spread indications
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