By the Numbers
Turning the corner on CMBS spreads as the Fed’s pace slows
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.
After weeks of lagging the strong performance in other parts of the market, CMBS and CRE CLO spreads have started to tighten in secondary trading. Low primary supply for at least the next few months should continue supporting spreads, which have already priced in the deterioration in fundamentals expected next year. Longer duration ‘A’ to ‘BBB’ classes of conduit deals so far have attracted only marginal investor interest. These mezzanine classes offer yields in the 9% to 10% range and enough credit support to withstand a moderate correction. And cleaner deals have the potential to tighten as the market’s recession fears prove too severe.
Conduit CMBS spreads have widened and the credit curve has steepened through 2022. Spreads of the ‘AAA’ classes in the primary market roughly doubled to tripled during the year (Exhibit 1). The shortest duration A1 class increased from about 50 bp to 150 bp. While the last cash flow (LCF) A5 class doubled from 100 bp to 200 bp. Spreads on the junior AS class, which has 20% credit support instead of the 30% of the super senior classes, also doubled from 125 bp in January to about 250 bp in November. However, the difference in credit compensation between the A1 and A2 class increased only modestly, from 75 bp at the beginning of the year to 100 bp as of the similarly benchmarked November deal.
Exhibit 1: Conduit AAA-rated class spreads at issue
Note: All conduit deals issued in 2022 used the SOFR swaps curve (P curve) as a benchmark at pricing, with the exception of the most recent two deals: The BBCMS 2022-C18 deal, which priced 11/18/2022, used the interpolated Treasury curve (IC) as a benchmark; and the 3650R 2022-PF2, which priced 11/21/2022, used the LIBOR swaps (S curve) as a benchmark.
Source: Bloomberg, Amherst Pierpont
Lower down the stack, there was similar pressure. Spreads of mezzanine classes of conduit deals at pricing more than doubled (Exhibit 2). As the Fed increased interest rates and the market became more volatile, many deals began to bypass issuing D and E classes, which are typically rated ‘BBB’ and ‘BBB-‘, respectively. The primary market across CMBS products slowed to a trickle during the third and fourth quarters and secondary spreads continued to widen. Conduit in particular suffered, in part due to its historically large exposure to office properties, which comprise about 33% of the collateral.
Exhibit 2: Conduit mezzanine spreads at issue
Note: Class ratings range from AA to BBB- at pricing. Spreads are to the SOFR swaps curve (P curve) except for the most recent deal shown. The BBCMS 2022-C18, which priced on 11/18/2022, was benchmarked to the Treasury curve and the A-/A rated C class was the lowest rated class sold.
Source: Bloomberg, Amherst Pierpont
Market volatility, fears of a recession and a steeply inverted yield curve steepened the slope of the credit curve. The difference in credit spread between the A1 and E class at the beginning of the year was about 300 bp (Exhibit 3). At the recent wides in early November, the slope had increased to 675 bp, even for a strong, regular issuer.
Exhibit 3: Example of credit term structure across conduit deals
Note: Classes may not be issued at par. Credit slope is the spread difference between the E class and the A1 class.
Source: Bloomberg, Amherst Pierpont
Over the last few trading sessions spreads in the secondary market have finally started to tighten across CMBS and CRE CLOs. Whether its due to the Fed signaling a slower pace of rate hikes or the relatively strong economic data soothing recession fears, investors have stepped back into CMBS hunting for high yields. Low CRE transaction volume will likely keep new supply limited for months to come, supporting the turn—or at least being in the vicinity of the turn—in spreads.
The ‘BBB’ D tranches of some conduit deals have recently been trading in the 600 bp to mid-high 600 bp area for yields of 10% to 10.5%. The ‘A’ C tranches for cleaner shelves are changing hands in the mid-500 bp for yields around 9%. Office exposure clearly needs to be monitored and priced accordingly, and evaluation has to be done on a deal-by-deal basis. These levels look compelling for a sector where spreads will almost certainly be tighter a year from now, and could contribute to excess return.
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