Investors should look to US commercial mortgage-backed securities with urgency, as the credit curve today may not be there tomorrow.
The sector is poised to perform after the Federal Reserve cut interest rates by 50bp on September 18. CMBS stand to benefit particularly from falling rates.
With uncertainty about when the rate cycle would tip now in the rear view mirror, the “wall” of borrowing costs should keep falling.
That will encourage borrowers to refinance or even acquire properties. In turn, that is likely to stimulate more issuance of CMBS.
However, spreads across the capital stack have tightened since the beginning of the year as the market priced in this virtuous circle early.
For example, newly issued triple-A 'last cashflow' conduit bonds have tightened 25bp this year, to 91bp, according to a Bank of America Global Research report from September 20.
Triple-B minus conduit spreads have done even better, tightening by 360bp to 540bp.
Even so, CMBS still offer some relative value compared to investment grade corporate bonds.
BofA’s report shows about a 20bp-25bp spread pick-up for triple-A conduit notes over corporates and about 200bp for triple-B minus conduit compared to high yield corporates.
Even with a substantially flattened credit curve, CMBS is just getting started at climbing out of the recession the past few years' rate hikes have plunged it into.
Even as the broader economy fared well, property values plummeted, real estate transactions were halted and delinquencies rose as borrowers struggled to service — or obtain — loans at higher rates.
With properties worth less than when the bank originated the loan, borrowers found themselves having to put up equity, just for the dubious pleasure of refinancing into a loan with the highest interest rate for over 20 years.
That whole paradigm has gone now. It will become easier for borrowers to refinance and for real estate investors to buy properties. This will feed into the CMBS market, where investors will be drawn back by a combination of relative value and growing confidence in how properties will handle higher rates.
Relative value, however, will not last forever. The investors first in line will get the most benefit from the performance of CMBS bonds. While the credit curve still offers investors some relative value juice, there isn’t an unlimited amount to go round.
Already, because of how much the bottom of the conduit capital stack has rallied in 2024, higher yield seekers are finding themselves squeezed out. The flattened curve is affording rarer opportunities to investors who crave yield.
Already hard to come by, yields are sure to fall further.
And if you’re an investor who plays at the top of the stack, you can still find bargains compared with corporate bonds. They are vanishing, however, as investors come looking for CMBS.
The value train is gathering steam, but has not yet left the station.