In today’s tight spread and low interest rate environment, the search for relative value opportunities can be challenging. The commercial real estate market has experienced strong growth in recent years as evidenced by continued property price appreciation, rising occupancies and rent growth across major property types.
Today’s chart highlights various high quality (AAA-AA rated) opportunities within the CMBS market. One investment trade idea I continue to like is CMBS interest-only (IO) securities. CMBS IOs have an attractive risk/return profile, offering spreads well in excess of similarly rated bonds within the CMBS market, while taking less duration risk.
A CMBS IO is a security holding a claim to the excess interest in a CMBS securitization and is created by stripping the coupon off the coupon payable to principal classes. Unlike residential mortgage-backed IO securities, which are highly sensitive to interest rates and prepayments, the negative convexity in CMBS is minimal due to strong loan protections. Prepay protection most commonly comes in the form of lockout and yield maintenance provisions.
CMBS IO securities offer stable cash flows, given the low risk of term defaults due to low coupons, favorable underwriting and supportive fundamentals. In addition, should refinancing conditions become unfavorable, IO holders could benefit from loan extensions which could delay loan maturities and increase the cash flow to the IO security. This makes CMBS IO a more appealing investment versus other mortgage- and asset-backed products.
Key Takeaway:CMBS IOs offer positive carry and attractive relative value versus comparable shorter-duration securities. Security selection is essential when identifying optimal risk/reward. It is important to analyze the differences in collateral quality, loan concentrations, prepayment protection and IO structure on a deal-by-deal basis. I have been biased toward seasoned deals, which offer greater upside potential if loans do not prepay in a worst case scenario.
The structure offers a hedge to rising severities, decreasing prepayment speeds and extension risk. Furthermore, the structural lockout provisions and collateral type offer more stability in terms of defaults and prepayments, compared to residential mortgage-backed securities.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
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High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
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