With more than $600 billion in total outstanding assets and a considerably faster pace of new issuance than counterparts like the Residential Mortgage-Backed Securities (RMBS) market, the market for Commercial Mortgage-Backed Securities (CMBS) represents a large, growing opportunity set. In recent periods, CMBS have also been cited as one of the few asset classes in which spreads were not yet materially compressed by a market-wide reach for yield, and many hedge funds have devoted substantial resources to their first forays into this market. But the risks facing CMBS investments have increased as well, and prices of the most compelling tranches have traded up considerably from their mid-year lows. Is it still worth investing in CMBS today?
Expected Returns in CMBS
On the one hand, there are still tailwinds in the CMBS strategy. Tranches higher up in the capital structure still enjoy wide spreads in capitalization rates versus alternate investment options like credit card receivables and auto loans. The sustained housing recovery has positive implications for CMBS as well, and the housing market has historically tended to act as a leading indicator of CMBS returns. On the other hand, those tailwinds may already be priced in. CMBS have broadly gained ground compared to many other fixed income sectors over the last six months. For example, the prices of slightly less than half the tranches in 2007-2008 CMBS vintage indices had risen from their 2013 summer lows by over 10% by year-end, while indices of both Treasuries and corporate bonds of comparable duration were roughly flat over the same period. Changes to Federal Reserve policy are also likely to add uncertainty to the outlook for CMBS in the coming months, as the market becomes increasingly concerned about pending interest rate hikes that may be still far in the distance, but creeping closer. Recently, CMBS specialists have noted that a number of the participants who played a pure “beta trade” (i.e., price appreciation) strategy in CMBS have withdrawn their capital, implying a growing consensus that CMBS prices have broadly approached fair value. Given these developments, it’s fair to question whether opportunities for strong returns still exist.
Moving Beyond the Beta Trade in CMBS
We think opportunities in CMBS still exist, but expect gains to be derived from security-specific sources going forward: we aren’t counting on a beta trade in 2014. Hand-in-hand with this, we expect that the market is most likely to reward investors conducting deep, loan-level credit and property analysis. We also think that recent trends in CMBS prices have made an active, defensive skill set and the savvy management of interest rate risk critical elements of successful trading of CMBS for this year.
CMBS spreads have generally compressed from the taper talk worries they achieved this summer. Price appreciation has been especially robust in the first two or three subordinated tranches of CMBS indexes (an area where hedge fund managers often find the most opportunities), with prices rising by between 10 and 20% for seasoned vintages (Exhibit 1). Given that these CMBS pricing trends have occurred absent any meaningful reversals in Fed policy expectations, we appear to be facing reduced expected returns across CMBS as an asset class.
Exhibit 1: CMBX Series 3 Index, Junior and Mezzanine AAA Tranche Pricing Since June of 2013
However, price appreciation across CMBS has not been uniform. Opportunities in junior AAA (“AJ”) tranches, for example, have recently ranged in price from 30 to 90 cents on the dollar. While securities heavy with class A properties or in gateway cities appear to be fully valued, securities backed by properties in less central locations and with tenant businesses in earlier stages of development are often still dramatically undervalued, and continue to have the potential for outsized returns. Meanwhile, many active traders of CMBS are very cautious of potential downside across retail-focused properties, particularly those properties with struggling anchor retailers. These credit risks are not always priced in given the recent run up of the asset class.
At this stage, we expect that CMBS returns are likely to be driven by the specific elements backing each security rather than by asset class trends, in part because of the relatively low levels of diversification and standardization of CMBS loan contents. It is not uncommon to see the largest loan in a CMBS tranche make up over 10% of total exposure, for example, or for the top several metropolitan statistical areas (MSAs) to make up the majority of a CMBS tranche. The composition of underlying properties by use (for example, retail versus office versus lodging) can also vary widely by security. Given this degree of concentration, the prospects of a CMBS tranche are often closely tied to the fate of its largest loans and properties, especially for the lower tranches on which hedge funds focus. This means that an intimate knowledge of and skill in evaluating top property prospects and top credit risks are central to CMBS managers’ return generation going forward. Even in the face of a broad-based CMBS market loss in response to something like a shift in market-risk premiums or a change in interest rates, investments in specific, misvalued CMBS tranches could still generate positive returns, particularly if the tranche’s larger underlying loans experience one or more positive catalysts.
The 2014 Opportunity Set
Some of the best values in CMBS currently appear to be in discounted legacy mezzanine and special situations AJs, where hidden gems are often underpriced, interest rate sensitivity is limited by lower prices compared to senior AAA tranches, and superior credit analysis can yield strong returns. Subordinated tranches can also offer better upside to improvements in credit quality than the most senior tiers of the capital structure, depending, of course, on current price levels. However, if managers are wrong about the underlying credits specific to their investments, the level of discounting and credit subordination baked into AJ and mezzanine tranches is typically not high enough to protect them from losses. Many AJ tranches begin to take losses after the loans backing their security lose 10% or more, for example. But again it’s also not uncommon to see the largest loan inside a CMBS tranche make up over 10% of the total portfolio. If a loan that size were to collapse, it would likely have a material impact on an AJ bond’s value. High quality loan level analysis is key.
Hedging and Short Opportunities in CMBS
Importantly, we expect that the advantages to fundamental analysis are not limited to the long side – it should also give managers an edge in shorting and hedging. It is not possible to short CMBS directly, so managers must hedge against credit risk using CMBX, which are indices of CDS on CMBS securities. This can involve substantial basis risk that can be mitigated but not avoided, and the management of that basis risk through the selection of which indices and tranches to use are an important part of any hedged CMBS strategy. In spite of this lack of direct shorting, however, we think that the CMBX instruments available to managers are concentrated and differentiated enough to allow not only for portfolio tailoring but also for active attempts to add value on the short side of their portfolios. CMBX tranches allow managers to target their hedges by both tranche and vintage year, and the contents of these indices are also fairly concentrated by loan: each index is comprised of only 25 credit default swaps, and each swap carries an initial 4% weight. Given this concentration, it is possible for managers with skill in fundamental credit analysis to evaluate the major underlying loans behind the tranches in a given CMBX index and do more than just provide protection on the short side. They should also be able to generate alpha.
Active rate hedging and management of portfolio duration will be increasingly important going forward, as we come closer to the next cycle of interest rate hikes by the Federal Reserve. Accordingly, we emphasize the importance of selecting managers with a proven skill set in interest rate management because market pricing of risks (i.e., rate exposure, in this case) in CMBS isn’t typically efficient or uniform. Many managers have already found attractive opportunities in assets like distressed or special situations AJs, where steep discounts in price mitigate interest rate exposure. Conversely, managers have also identified several CMBX tranches in which interest rate risk does not yet appear to be adequately priced in, creating shorting opportunities. As we come closer to the point where the Fed begins to raise interest rates and rate volatility rises, it is likely that these types of opportunities will persist.
Given the reduced expected returns and heightened risks currently facing CMBS markets, there are three skills we consider critical in trading the market well in 2014: credit selection, rate risk management, and active shorting. Two out of three is no longer good enough.
Austin Head-Jones, CFA is an Associate Director working in Portfolio Management with a focus on fixed income relative value and long/short credit investments. Her experience includes due diligence and ongoing monitoring of hedge fund managers across a broad spectrum of strategies and asset classes. Prior to pursuing her MBA Austin worked at Cambridge Associates, LLC, a financial consulting firm in Boston, MA, where she specialized first in customized private equity portfolio construction and financial modeling and later in international and emerging markets equity fund research. Austin received her MBA from the University of Chicago Booth School of Business with concentrations in Analytic Finance, Econometrics and Accounting. She graduated magna cum laude from Brown University with a BA in International Relations.
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