Is the juice worth the liquidity squeeze? Why taking extra risk in CMBS may not pay off

Over recent months, BBB- rated commercial mortgage-backed securities (CMBS) have outperformed the AAA rated part of the CMBS market, as well as  high yield corporate bonds. However, in our opinion, the outperformance is due to some unusual technical factors.

The stable yield spreads seen for CMBS BBB- offer the appearance of stability. There is also the appearance of liquidity with little inventory of BBB- CMBS, and newly-issued bonds clear quickly in the syndicate process. However, what looks like demand is in fact an outcome of the small tranche sizes in the average CMBS issue.

With few bonds to clear, a broad investor base is not required. In short, we think investors are taking on liquidity risk, which may not be readily apparent, and this liquidity risk comes in addition to an illusion of low price volatility. We believe these risks are two for which investors are not adequately compensated.

The anatomy of CMBS

In 2019, the average CMBS “conduit pool”, totaled $911 million. Super-senior AAA classes make up 70% of the average deal. Indeed, the largest part of a given deal - the 10-year AAA “last cashflow” segment - alone makes up roughly 50% of the average issue. This means that when an issuer brings a new CMBS deal to market, they have over $450 million in 10-year AAA bonds to sell. Importantly, limitations on 10-year AAA demand is the largest limiting factor for conduit deal sizing. This is why individual deal sizes have remained relatively constant since 2011.

BBB- classes, on the other hand, make up only 2% of that $911 million total. So when that same issuer brings a new deal to market, they only need to sell $18 million BBB-‘s; a relatively straightforward task by comparison. If fact, this class is likely taken down by only one or two investors.

Typical conduit structure

Source: Schroders

Because BBB- classes are so much smaller, they often attract enough interest at issuance to become many times oversubscribed. This creates a false perception of liquidity and a deep investor base. The reality is it only takes a few investors to fill the BBB- tranche. The total number of buyers in the market remains very small. This holds especially true in a low yield environment, with investors reaching further out the risk spectrum to pick up incremental spread.

As a result, conduit BBB- classes are trading tighter vs the last two years of spread history than other products are, both within CMBS and versus corporates (lower percentile equals “richer” spread).

Conduit spread – 2-year range

Source: JP Morgan, Schroders

Moreover, BBB- CMBS have been more resilient to spread widening than corporate high yield when risk appetites have fallen.

Resilience of BBB- spreads

Source: JP Morgan, Schroders

This means that the CMBS credit curve is very flat by historical standards.

Conduit credit curve – AAA-BBB- Curve

Source: Barclays, Schroders

Are investors being paid enough?

In the current market environment, liquidity may not appear to be a problem. However, if a downturn hits markets, the ability to exit these small segments of the average CMBS issue could become very challenging. Given that spreads have already compressed, and liquidity could be challenged, we do not think investors are adequately compensated.