By the Numbers
Newer issues offer best relative value in 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.
Newly issued conduit CMBS has steadily widened this year, especially below the most senior class and especially compared to similar corporate debt. Investors looking for incremental spread should rotate out of seasoned ‘AA’ through ‘BBB’ conduit CMBS into new issue paper, and out of ‘A’ corporate debt and into ‘AAA’ conduit CMBS.
The primary versus secondary CMBS market
New issue conduit CMBS paper below the ‘AAA’ super-senior class is coming to market wide of seasoned conduit paper with similar duration and similar rating (Exhibit 1). The last cash flow A5 super-senior tranches of new conduit deals came to market at the beginning of the year at a spread to the Treasury curve of 105 bp, which was 20 bp wide of the conduit CMBS ‘AAA’ index for 8.5-year and longer paper. That spread has stayed roughly consistent despite market volatility, with the widest A5s coming at only 25 bp over the OAS of the index. By comparison, the AS classes have widened again the ‘AAA’ index. The junior AS classes are mostly still ‘AAA’ with nearly identical weighted average lives as the super-senior LCF but with somewhat less credit enhancement. The new issue AS classes have widened this year compared to seasoned paper with early deals coming about 50 bp over the ‘AAA’ index, while three of the last four deals have had AS classes price 75 bp over. The ‘AA’ B class was pricing a 10 bp over the AS at issue, but in recent deals is now 35 bp wide.
Exhibit 1: New issue conduit CMBS versus seasoned paper, AAA to AA-
Note: Data thru 6/8/2022.
Source: Bloomberg, Amherst Pierpont Securities
The story is similar lower in the ratings stack. Classes C (‘A’) and D (‘BBB’) began the year pricing in-line to through their comparable secondary market conduit index. Over time these have widened out (Exhibit 2). Classes with more credit exposure have more variation in pricing at issue, but the trend has been similar.
Exhibit 2: New issue conduit CMBS versus seasoned paper, A to BBB
Note: Data thru 6/8/2022.
Source: Bloomberg, Amherst Pierpont Securities
New issue has likely widened to seasoned paper for a couple of reasons:
- Commercial real estate prices began to stagnate early in the year and are now modestly declining across most property sectors, so deals with even a year or two of seasoning have benefited from property price appreciation that provides a bit of a buffer
- Higher interest rates have increased borrowing costs and, so far, cap rates have widened only a tiny bit
- Office properties, often the largest component of most conduit deals, still face the most uncertain outlook
- Inflation weighs heavily on properties that have long lease times, which prevents raising rents to market levels, and seasoned deals have at least a few quarters of performance for investors to examine
None of these factors is likely to resolve quickly, meaning new issue conduit CMBS could price wide of seasoned paper until there is a definitive improvement in the economic outlook, and recession fears fade.
Conduit CMBS is wide to investment grade corporates
Long duration ‘AAA’ conduit CMBS spreads historically have closely tracked ‘A’ corporate bond spreads (Exhibit 3). Recently, investment grade corporate bond spreads have tightened 9 bp to 22 bp across rating tiers since recent wides in late May. The ‘A’ corporate bond index has tightened 19 bp in OAS. The ‘AAA’ CMBS conduit spreads for long duration securities have also stabilized in the secondary market , but lagged the move tighter.
Exhibit 3: AAA conduit CMBS versus IG corporate bond spreads
Note: The broad investment grade corporate bond index (IG Corp, above) has a median rating of BBB+. OAS to Treasury. Data thru 6/8/2022.
Source: Bloomberg, Amherst Pierpont Securities
The correlation between the level of CMBS ‘AAA’ and ‘A’ corporate spreads (Exhibit 4) is significant, with a beta of 1.03 and an R-squared of 0.88 (Exhibit 4). This tight relationship holds over long periods of time. Some trading desks and investors use investment grade corporate bond funds or indices as a macro hedge against their CMBS portfolios. This can be effective over longer periods of time, though the biggest divergences in performance between the two tend to be during periods of high market volatility.
Exhibit 4: Correlation of IG corporate A-rated OAS vs CMBS AAA +8.5-year OAS
Note: Regression is on daily data since January 2019, but R-squared is stable around 0.85 to 0.9 for much longer time periods. Regression is on the level of the spreads, not the differences. Source: Bloomberg, Amherst Pierpont Securities
Long-duration ‘AAA’ conduit paper currently has an average OAS of 125 bp in the secondary market, compared to ‘A’ corporates with an average OAS of 105 bp. The CMBS is trading 18 bp wide of projections based on the level of corporate spreads (Exhibit 5). The AAA conduit CMBS spreads have averaged 1.3 bp higher than ‘A’ corporates over the last 3 years; the CMBS are currently 20 bp higher, though that’s down from a recent peak of 27 bp near the end of May.
Exhibit 5: Projections based on regression analysis
Source: Bloomberg, Amherst Pierpont Securities
CMBS should eventually tighten to corporate debt, though during the pandemic the persistent deviations from the regression line have occurred when CMBS trades wide during periods of volatility. Corporate bonds have now retraced a bit of their outperformance over the past few weeks, with high yield spreads widening more than investment grade. Recession fears are likely behind this move as well. If inflation prints improve it’s possible that corporates snap back again and CMBS takes longer to follow, but eventually the spreads of the two will likely again converge.
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