By the Numbers
Balancing return and risk in last-cash-flow conduit CMBS
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.
The front last cash flow of a conduit CMBS deal typically prices at new issue two basis points tighter than the last cash flow due to its slightly shorter weighted average life. In many 2017 to 2019 vintage deals, where those bonds are now trading at high premiums, the front last cash flow now is trading 10 bp to 12 bp wide of the last cash flow. Investors can capture additional yield in the front last cash flow and may benefit from tightening as credit issues resolve, but investors need to pay attention to the potential impact of prepayments and defaults.
An example of the spread reversal between the front LCF and LCF security is in the BMARK 2019-B9 deal (Exhibit 1). The A4 is trading at a spread of 75 bp with a projected yield to maturity of 1.84%, while the A5 has a spread 10 bp tighter at 65 bp with a projected yield of 1.75%, both assuming 0 CPY and 0 CDR.
Exhibit 1: Comparison of Front LCF and LCF for BMARK 2019-B9
Note: Levels shown are indicative only. Data as of 7/15/2021.
Source: Bloomberg, Amherst Pierpont Securities
The principal window for the A4 is 7/28–12/28, and the A5 is 12/28-1/28 resulting in very comparable average lives of 7.3 and 7.4 years, respectively. At 100 CPY, however, the principal widow of the A4 widens to 12/25-6/28 and the average life shortens to 6.9 years, with a resultant drop in projected yield of 11 bp from 1.84% to 1.73%. The A5 also shortens to 7.2 years and drops 8 bp of yield. Notably in the 50 CPY scenario the average life and projected yield of the A5 is nearly unchanged while the A4 does realize about half of its performance degradation at 50 CPY.
The reason for the difference in potential underperformance is that there are several loans in the deal–including the largest loan representing 10% of the trust balance–that have open periods of seven months. At super premium dollar prices, the loss of those extra months of interest cash flow is enough to cause a deterioration in performance, more so for the front LCF A4 than the A5 whose principal window is narrower.
There are a variety of credit concerns in the deal. Currently two loans of 50, totaling 1.9% of the trust balance, are in special servicing, two are delinquent including the largest loan (10.74%) which is a New York City office property, another 14 are on the watchlist (30.6%) and one is in grace period (3.9%). For illustrative purposes, the credit scenarios in Exhibit 1 assume a default rate of either 1 or 2 CDR per year, and a loss severity of 30%. Neither of these classes has a principal loss, but the at 1 CDR the cumulative loss to the collateral is 2% and at 2 CDR there is 4% loss. The front LCF A4 underperforms by 38 bp to 45 bp at a default rate of 1 CDR depending on the prepayment speed, while the LCF A5 is stable at 1 CDR and experiences virtually the same 9 bp drop in performance if prepay speeds accelerate to 100 CPY. The LCF A4 is also mostly stable in the 2 CDR scenario, while the A5 could experience significant underperformance, with the projected yield dropping to 0.84% or 0.75% as the average life of the bond shortened to roughly 4.5 years.
Exhibit 2: Comparison of Front LCF and LCF for BMARK 2018-B8
Note: Levels shown are indicative only. Data as of 7/15/2021.
Source: Bloomberg, Amherst Pierpont Securities
This is not to suggest that buying the front LCF isn’t a good relative value play, but only that investors need to carefully examine the collateral from a prepay and credit perspective. Exhibit 2 shows the same comparison for the A4 and A5 in the BMARK 2018-B8 deal. The projected underperformance of the A4 in this deal is about the same at 100 CPY – a loss of 11 bp of yield – but potentially much more severe in default scenarios of 1 CDR or 2 CDR where the yield falls by up to 69 bp and 170 bp, respectively. This is also exacerbated by the higher dollar price of the securities. However, the collateral in this deal is much cleaner. Only one loan of 41 is in special servicing (5.4%) and 11 are on the watchlist (25%). Even at the higher dollar price, the overall risk of a credit event at this point is much lower, and the underperformance at 100 CPY is relatively modest.
Investors can pick up 10 bp to 12 bp of additional spread in front LCF securities, and as those securities roll down the curve and if credit conditions of the underlying loans improve, they could potentially tighten and significantly outperform the LCF.
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