By the Numbers

Conduit CMBS last cash flows linger wide to corporates

| June 3, 2022

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 ‘AAA’ last cash flow classes of conduit CMBS, whose spreads roughly track their ‘AAA’ corporate cousins, remain stalled at recent wide spreads despite tightening in corporate credit. The dislocation offers an excellent relative value opportunity for investors to pick up seasoned ‘AAA’ LCF pieces about 75 bp wide of ‘AAA’ corporates. The opportunity is particularly compelling for insurance companies, where recent rule changes by NAIC have significantly lowered capital charges for ‘AAA’ securities relative to other ratings categories.

Investment grade corporates tighten while CMBS lags

The Bloomberg aggregate investment grade corporate bond index touched post-pandemic option-adjusted spread (OAS) wides of 172 bp on May 20 but have since retreated by 20 bp to 152 bp (Exhibit 1). The ‘AAA’ securities in the index have been less volatile overall but show similar dynamics. ‘AAA’ corporate spreads hit 72 bp on May 20, below the post-pandemic wide of 83 bp in early March 2022. Similar to the broader investment grade index, ‘AAA’ spreads have tightened about 10 bp to 61 bp.

Exhibit 1: Investment grade vs CMBS last cash flow OAS

Note: Spreads as of 5/31/2022.
Source: Bloomberg, ICE BofA US Corporate AAA Index OAS from FRED, Amherst Pierpont Securities

‘AAA’ last cash flow (LCF) conduit CMBS broadly track the investment grade bond market, in particular ‘AAA’ corporate sector, though spreads between CMBS and IG corporates have diverged during this latest move. CMBS ‘AAA’ LCF spreads stabilized during the last week of May but did not tighten and now stand at 135 bp. The spread difference between CMBS ‘AAA’ LCF and ‘AAA’ corporates is currently 74 bp, a level not seen since the dramatic pandemic driven spread widening during the March to May period of 2020. The spread difference between the two ‘AAA’ indices has averaged 28 bp over the past three years.

Prefer seasoned LCF with moderate office exposure

The advantage of seasoned deals is that the pandemic stress has provided a window into long-term performance. For example, CF 2019-CF3 A4, a ‘AAA’ LCF class, is fairly representative of the sector (Exhibit 2). The bond has a 3.0% coupon, a current J-spread of 125 bp, a discount dollar price and an average life of 7.5 years. And credit support has increased a bit above 30% thanks to modest paydowns.

Exhibit 2: Example of a clean, seasoned AAA LCF

Note: Indicative pricing as of 5/31/2022. Please contact desk for updated level.
Source: Bloomberg, Amherst Pierpont Santander

Office exposure is 35% of the deal, which is in line with its representation across conduit deals. Hotel exposure is low at 6% and residential is relatively high at 27%. There is one loan representing 3.2% of the balance currently in foreclosure. The single loan in foreclosure is actually secured by six small multifamily properties in Brooklyn, NY. The loan defaulted and the borrower requested forbearance a few months into the pandemic. The borrower recently requested that the foreclosure process be terminated and is awaiting a court decision. Given the borrower’s request to terminate foreclosure and the exceptionally strong property price appreciation during the pandemic, it seems likely that the loan will either cure or the losses due to foreclosure will be minimal.

The relative cost of capital for insurance companies

The wide spreads for ‘AAA’ LCF classes are particularly compelling for insurance companies seeking a higher return. The NAIC at the end of last year lowered capital charges for ‘AAA’ securities and increased charges for most other ratings classes. The capital charges for ‘AAA’ securities are 0.16% with capital at other rating levels substantially higher—between 169% and 1356% of the ‘AAA’ charge (Exhibit 3). For ‘AAA’ LCF classes, a spread of 135 bp equates to 8.4375 bp of spread for every basis point of capital. By comparison, a ‘AA+’ security would need a spread of 228 bp to match the spread per basis point of capital in ‘AAA’; a ‘A-‘ security requires a spread of 861 bp, and a ‘BBB-‘ security would need a spread of more than 1800 bp to achieve a similar return on capital at current spreads of the ‘AAA’ LCF class. Investors are unlikely to find corporate debt offering these breakeven spreads.

Exhibit 3: Breakeven spreads across NAIC rating categories

Note: *Spread needed to match the ‘AAA’ spread per basis point of capital of (135 / 16 ) = 8.4375.
Source: NAIC, Amherst Pierpont Santander

The long end of the yield curve has stabilized, and the equity market has found a footing. Commercial real estate prices increased modestly across the board in April after stagnating earlier in the year. As duration buyers return to the market, the LCF classes of conduit deals will likely tighten.

Mary Beth Fisher, PhD
marybeth.fisher@santander.us
1 (646) 776-7872

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