By the Numbers
CMBS credit risk reprices as new issue returns
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.
Spreads in new non-agency CMBS have painted a mixed picture in recent weeks. ‘AAA’ to ‘A’ classes of new deals have steadily tightened from recent wides. But down the capital stack in ‘BBB’ and lower-rated tranches, spreads have hit multi-year wides, with yields from the low- to mid-teens. Lower investment grade CMBS now offer spreads similar to high yield corporate debt. That prices in a lot of bad news. Investors should consider cleaner mezzanine CMBS and CRE CLO classes, where performance is still good and there is enough credit enhancement to support ratings.
Fixed income spreads across all products widened to Treasuries as Silicon Valley Bank and others failed in March this year (Exhibit 1). Spreads in investment grade and high yield corporates recovered fairly quickly, but spreads in structured products have been stickier, particularly in non-agency CMBS. Average option-adjusted spreads (OAS) to the Treasury curve for non-agency CMBS rose above 200 bp in March and have stayed there. Since January 2015, non-agency CMBS spreads only exceeded these levels at the onset of the pandemic.
Exhibit 1: Fixed income index spreads across products
Note: Indices are Bloomberg aggregates across products. Data through 6/8/2023.
Source: Bloomberg, Santander US Capital Markets
Lower-rated non-agency CMBS classes have continued trading wider in the new issue markets, as shown in recent conduit deals. The ‘AAA’ sequential classes of new conduit deals have tightened since touching recent wides in November 2022 and March 2023 (Exhibit 2). The ‘AA’ and ‘A’ B and C tranches have also tightened, while the lower investment grade rated D and E classes continue to print at new wides (Exhibit 3).
Exhibit 2: New issue AAA-rated conduit spreads have been tightening
Note: New issue pricing of select conduit classes. The A1 to A5 classes of conduit deals are AAA-rated sequential pay classes with identical credit enhancement, but gradually longer duration. The AS class is also usually AAA-rated but has the longest duration of the A classes and less credit support.
Source: Bloomberg, Santander US Capital Markets
Two new conduit deals that priced in mid-May had the ‘BBB+/BBB’ D class price at about 780 bp to the SOFR curve, while a ‘BBB/BBB-‘ E class came at 970 bp over SOFR. All D and E classes of those deals had 10-year weighted average lives at origination. That pushes the all-in yields of those low investment grade rated conduit classes into the low teens, roughly 11.5% to 13.5%.
Exhibit 3: BBB-rated conduit spreads have been widening (D and E classes)
Note: New issue pricing of select conduit classes. B classes are typically AA-rated and C classes are usually A-rated. The D and E tranches are usually low investment grade in the BBB+ to BBB- range.
Source: Bloomberg, Santander US Capital Markets
The widening is not specific to conduit, as it has been occurring across other lower-rated classes of non-agency CMBS and the discount margins of floating-rate CRE CLOs. CRE CLOs are comprised of floating-rate transitional loans, and the 500 bp of Fed hikes have put borrowers under pressure though deal performance has, so far, mostly held up fairly well.
The new issue market for CRE CLOs has all but shut down since the Fed began raising rates in earnest, with only four deals pricing since June of 2022 (Exhibit 4). Three of those deals have come in 2023, with the SGCP 2023-FL5 deal pricing on June 1, 2023. The discount margins for the BBB-rated D class and BBB minus rated E class came at 650 bp and 800 bp over 1-month term SOFR, respectively. With 1-month term SOFR currently about 5.15%, this puts the yields of the 2-year to 5-year WAL CRE CLO classes, depending on extension, in the same 11% to 13.50% range as the much longer duration fixed-rate conduit D and E classes.
Exhibit 4: Discount margins of lower-rated investment grade CRE CLO classes
Note: New issue pricing of select CRE CLO classes. The D and E tranches are usually low investment grade in the BBB+ to BBB- range.
Source: Bloomberg, Santander US Capital Markets
The average OAS of the high yield corporate index is 470 bp over Treasuries with an option-adjusted duration of 3.6. Depending on the sector and tenor, new issue BB to B rated high yield corporate bonds have been coming to market with yields from 7.75% to 9.75%, well below the yields of higher rated non-agency CMBS.
The fundamental picture of commercial real estate is poor in office, and cautious in other sectors including some multifamily and retail. But that caution appears more than priced in for lower-rated non-agency CMBS, which continues to linger wide with the overhang of sales from the failed bank portfolios. Investors should step into cleaner CMBS and CRE CLO deals to pick up yields in the mezzanine classes in the low teens, where performance is still good and there is enough credit enhancement to support ratings.
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