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CRE exposure vs corporate credit in BBBs

| November 22, 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.

The ‘BBB’ sector of the investment universe continues to draw significant scrutiny as investors evaluate economic scenarios and begin making allocation decisions for 2020. A base case of globally low interest rates amid softening economic growth has sharpened the focus among investors reaching for yield on the lower tier of investment grade products. The wide dispersion of yields available across the ‘BBB’ universe of senior unsecured corporate debt versus commercial mortgage-backed securities clearly indicate that ratings are only capturing part of the market’s assessment of risk.

Compensation for risk varies considerably across products that have similar ratings (Exhibit 1). The average yield for ‘BBB’ senior unsecured corporate credit is currently lower than arguably the cleanest equivalently-rated CMBS collateral – the B and C classes of Freddie Mac K-deals. Even when equivalently-rated, the C classes typically have higher yields than the B’s, reflecting the lower level of credit support in the waterfall structure.

Exhibit 1: Yields available across ‘BBB’ corporate credit versus CMBS

Note: Data only includes conduit CMBS D classes which are rated Baa3/BBB- by at least two rating agencies and those ratings are not mixed. The Bloomberg Barclays Corporate credit BBB+/BBB/BBB- curve (BS75) includes issuers that have mixed ratings, and the mid curve is a weighted average yield of all bonds outstanding in the category. All yields are from BVAL on Bloomberg. Source: Bloomberg, Amherst Pierpont Securities

However, yields for both B and C classes of Freddie K-deals that are ‘BBB’ rated currently lie well within the upper half of the range of yields for ‘BBB’ corporate credit. This is likely a reflection of the tendency for upwards ratings migration of the B and C classes as loans are defeased over time, and the extraordinarily low delinquency and loss rates – less than 6 bp and 1 bp of outstanding principal balance, respectively – in the K-deal program.

Conduit CMBS D classes rated BBB- predominantly offer yields higher than equivalently rated corporate debt and Freddie B and C classes across the maturity spectrum. The range of yields available reflects factors such as the diversity of underlying collateral, the thickness of the tranche and the credit protection provided by the rest of the structure.

Relative spreads between CMBS and investment grade corporates

The historical performance of IG corporates and CMBS does tend to trend together (Exhibit 2) during periods of broad market moves, including the late 2018 risk-off move followed by the sustained rally in rates and most spread products through much of 2019. There have also been periods where performances have deviated due to particular events in corporate credit in 2013-2015 that tended to provoke less volatility in CMBS. If the CMBS ETF covered the financial crisis, it’s almost certain that the positions would be reversed, with the IG corporate index showing overall less volatility during a period when CMBS defaults hit record highs.

Exhibit 2: Performance of IG corporate bonds vs CMBS

Note: iShares exchange-traded funds LQD and CMBS are designed to mimic the price and yield performance of the US Dollar Investment Grade Corporate Bond Index and the Bloomberg Barclays US CMBS (ERISA Only) Index. Daily data since 3/1/2012; CMBS ETF began trading in February 2012. Source: Bloomberg, Amherst Pierpont Securities.

Although both LQD and the CMBS ETFs are constructed from the broader investment grade universe of bonds, it’s possible to infer that a ‘BBB’-specific index in both sectors would show similar performance with greater volatility. Spread volatility generally tends to increase as ratings decrease, and particularly so during periods of sharp market corrections.

The questions investors may need to ask themselves for 2020 when making allocation decisions between corporate and CRE, is how stable they believe the fundamentals of each sector is and whether they suspect the next economic downdraft will emanate from equities or real estate.

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