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By Jose A. Pluto, CFA
After a difficult period, commercial mortgage-backed securities are benefiting from a more favorable macro backdrop and improved sentiment.
Coming into 2024, commercial mortgage-backed securities (CMBS) were among the most dislocated sectors in fixed income, with yields at levels seldom seen outside of extreme environments like the Global Financial Crisis and COVID-19 scare.
Commercial real estate (CRE) was a notable casualty in the Federal Reserve’s fight against inflation, as higher interest rates increased borrowing costs and cast a shadow over valuations.
Credit tightening after the March 2023 mini crisis in regional banking combined with secular dynamics around “work from home” and the future of office usage further contributed to negative sentiment.
Most recently, U.S. CRE reappeared in the news due to loan portfolio challenges at New York Community Bank (NYCB) and certain foreign institutions.
Still, sentiment has begun to shift with a more favorable macro backdrop. As economic data have increasingly pointed to the Fed achieving a soft landing, views on commercial real estate have improved.
Borrowing costs have eased materially as key pricing benchmarks for CMBS loans have declined since October’s peaks (including an 80+ basis-point drop in the 10-year Treasury yield).
As markets have priced in a less dire CRE outlook, CMBS have seen spread compression through the first week of February with the Bloomberg U.S. CMBS 2.0 Single-A and BBB indexes tightening by over 130 and 160bps, respectively, since year-end.
While the office sector remains challenged by multi-decade highs in vacancy rates, fundamentals remain stable for the other sectors that represent over 70% of outstanding CMBS.
In particular, revenue trends among retail, hospitality and industrial properties remain robust. Credit performance excluding office loans has been stable, with delinquencies running at about 4% - roughly unchanged over the past 12 months.
Despite headwinds from tighter CRE lending, according to data from Deutsche Bank, timely payoff rates for maturing conduit CMBS loans have been running in the mid-70% range.
More generally, CMBS can provide exposure to specialty property types such as data centers, life sciences research properties and cold storage facilities that have benefitted from strong fundamental tailwinds.
We continue to favor select investment-grade mezzanine opportunities in CMBS. Even with recent tightening, spreads generally remain wider than historical norms versus corporate credits.
The market continues to afford attractive security selection opportunities in stories with low leverage, significant credit enhancement, strong value retention and a clear path to financing.
By leveraging loan data along with research on property, market and sector insights, we are seeking to identify opportunities that should prove resilient through the economic cycle.
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