Wider CMBS Spreads Unlikely to Tighten Soon

MBA (7/30/2008 ) Murray, Michael
While wider synthetic spreads increase yields for commercial mortgage-backed securities (CMBS) investors, little CMBS issuance is likely until spreads tighten considerably, industry analysts said.

The synthetics, known as CMBX, are a synthetic family of indices based on U.S. CMBS, which provides investors with liquid, transparent exposure to CMBS of a unique vintage profile as a form of pricing protection. As spreads widen on financials and retail, investors are adding CMBX derivatives into the mix to short the CMBS market and that pricing reflects on the cash bonds.

Darrell Wheeler, head of securitized strategy at Citigroup Global Markets Inc., New York, said the “technicals” in CMBS are more important than legislation, property fundamentals and confidence in ratings agencies as major market factors that influence investors.

For example, Citigroup recorded .42 percent CMBS delinquencies last month—less than the previous month.

"They already know the fundamentals are fine," Wheeler said. "They are just more concerned, at this stage, that the technicals can take them wider, so the mark-to-market is a killer."

The result has been a “wave pattern” where investors short the CMBX index with few if any investors naturally going long on that index, Wheeler noted.

"Most people are just riding on these waves," he said. "They are still buying [CMBS bonds]. They just do not want to push the spreads tighter.”

Alan Todd, head of global structured finance research at JP Morgan Securities, New York, said CMBX indices are moving back wider since March, and he would not be surprised to see CMBX get near March levels again. He noted the CMBX-2 A-rated index at its widest spread of 900 basis points (bps) in March before tightening into 400 bps, and now back to 775 bps.

“We are still tighter than the ‘wides,’ but I wouldn’t be surprised if we touched the wides or get real close to them at some point going forward,” Todd said.

JP Morgan Securities reported spreads would continue to trade nearly 170-230 bps over swaps but slightly wider in the very near term.

Todd expects transaction volume to remain muted for the medium term as bid/offer levels remain wide and tighter underwriting standards limit leverage and the ability for opportunistic buyers to “put cash to work.”

Todd said the CMBS market could possibly see one to three more deals this year, but he would not expect any consistent deal flow before the end of the first quarter or in the second quarter of 2009.

Wheeler said spreads would need to tighten by nearly 100 more bps for CMBS issuance, and he does not expect that tightening to occur until at least October. With AAA bonds and BBB bonds trading, he said investors would rather purchase securities at wider yields than make any effort to move spreads tighter during current times of economic uncertainty.

"With all of this negative news out there on housing and everything else, there is no real impetus—and nobody is in a rush—to see spreads come in," he said. "Even if I'm somebody who sees pretty good value in the BBB bonds—with a possible 23 percent yield today—[CMBS investors] are not going to go rock the boat and go buy them all. They are going to be selective because they know there are only a few of them out there buying them. We have seen people doing that."

"Once these factors external to CMBS get resolved, the market can regain focus on internal developments and trade in a more fundamental direction," Todd said. "This will not happen any time soon, however, and until that time arrives we believe spreads at the top of the structure will continue to tread water."

JP Morgan Securities reported that AAA cash bond spreads offered fundamental value at current levels but technical pressure—including balance sheet constraints—and macro shorts applying pressure to similarly-rated CMBX tranches, would likely keep spreads at their current levels.

Balance sheet pressures remain a factor as major financial institutions continue to write down non-performing mortgages. Balance sheet constraints combined with current capital market spreads make CMBS originations more unlikely because originators would not want to hold the loans on the balance sheets, and whole loan spreads are also not competitive with life companies.

"We're seeing a lot of technical trading,” Wheeler said. “As the volatility goes out of that technical trading, that can take a period of six to 12 months. You'll see spreads probably tighten over that horizon."