In December 2016, the commercial mortgage-backed securities (CMBS) market officially adopted risk retention rules as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The rules were designed to promote an alignment of interests between sponsors and investors. Risk retention requires lenders originating loans to retain a 5% slice of each CMBS deal for five years, thereby forcing issuers to have ‘skin in the game.’
Risk retention has been the biggest regulatory risk the CMBS industry has faced since the financial crisis. Initial fears were largely overblown as the market has successfully implemented these rules with 27 compliant conduit and single-asset, single-borrower deals priced in 2017.
Risk retention deals have come to market in various forms with three being most prevalent in the marketplace. The most common thus far has been a vertical structure, which requires the issuer to retain a 5% interest across all of the bond classes. In a horizontal structure, a 5% strip at the bottom of the capital structure can be retained by a third party, B-piece investor. A third option is an “L” shape, which is a combination of a vertical and horizontal structure.
This week’s chart highlights the spread ranges among conduit deals priced in 2017 with a vertical or horizontal structure. For AA- and A- rated securities, horizontal structures generally have less spread dispersion than vertical risk retention deals. In some cases the relative spread between the two structures may be inconsistent given the underlying credit fundamentals of each deal.
Key Takeaway:In today’s tight spread and low interest rate environment where risk assets have been outperforming, the search for relative value opportunities continues to be challenging. For bottom-up credit investors, there could be incremental value in vertical risk retention deals over horizontal deals. In the post-risk retention era, I would expect spread variances among risk retention forms to converge over time as investors become more comfortable in analyzing the structures.
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.
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