CIO WM Research 25 June 2014

Transcription

1 CIO WM Research 25 June 2014 US fixed income Diversify your holdings with commercial mortgage backed securities (CMBS) Leslie Falconio, strategist, UBS FS James Rhodes, CFA, analyst, UBS FS Commercial mortgage backed securities (CMBS) are bonds collateralized by loans on commercial and multifamily real estate loans. CMBS offer investors a liquid vehicle to make diversified investments in the commercial real estate debt markets. The market survived the credit crisis of 2008, and although issuance is still much lower than it was during the peak, the underwriting quality of the loans is stronger. We think CMBS represents good relative value, particularly versus investment grade corporate bonds. For any investors concerned that now is not the wisest time to reach out the maturity spectrum and down the credit curve, we believe an allocation out of corporates and into CMBS offers the opportunity to decrease duration, increase credit quality and pickup incremental yield. What are CMBS? Commercial mortgage backed securities (CMBS) are bonds whose payments derive from a pool of mortgage loans on commercial and multifamily real estate. These properties typically include apartment buildings, office buildings, retail establishments, hotels and industrial properties. Through the process of financial securitization, several loans are pooled and packaged into a deal structure, which is then carved into separate slices called "tranches" that allow for different levels of credit risk, roughly analogous to the process by which residential mortgage loans are pooled to create mortgage backed securities (RMBS). This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures that begin on page 9.

2 Compared to their residential mortgage cousins, however, CMBS structures are usually relatively simple and straightforward. For example, in a typical "conduit" structure, the bonds are fixed rate and sequential pay, with monthly payments (e.g., principal and interest) paid to the most senior class first, then the other subordinate classes in the order of seniority; this is euphemistically referred to as a "waterfall" structure. Any losses are absorbed in the opposite order, i.e., the lowest rated classes take losses first. Unlike residential mortgage loans, commercial real estate loans are not allowed to prepay their principal without some sort of penalty, so prepayment analysis is a much less important factor for CMBS. In addition to collateralization and subordination, CMBS bonds can be credit enhanced in other ways (e.g., loan reserve funds, letters of credit, cross default and cross collateralization provisions, bankruptcy remote structures), which offers certain relative advantages for investors. For example, compared to residential mortgage backed securities, CMBS bonds have stronger call protection; and compared to direct commercial real estate whole loans, CMBS bonds are more liquid and offer various time- and credit-tranched levels of participation that make them more attractive to a greater pool of investors. Like real estate investment trust (REITs) equities, CMBS bonds offer investors the opportunity to make a diversified investment in commercial real estate, albeit in debt versus equity. Fig. 1: CMBS deal structure example Loans --> Loss Allocation Last First Source: UBS CIO WMR. AAA Class AA Class A Class BBB Class BB Class B Class Non-Rated Class First / Lowest Last / Highest Return of Principle / Risk How big is the market? The total amount of CMBS outstanding was USD 618 billion, as of 1Q2014, according to the Securities Industries and Financial Markets Association (SIFMA). With over USD 3 trillion in commercial real estate loans, that implies that almost 20% has been securitized. On both measures that's lower than the residential mortgage market counterpart, where over USD 8 trillion is outstanding and the securitization rate is over 50%. The credit crisis of 2008, in particular, brought the market to a screeching halt from which it is still recovering. As the figure shows, the amount of issuance lags well behind the peak years around the middle of the last decade. Fig. 2: CMBS conduit deal issuance Supply (USD bn) Conduit deals ytd Source: Commercial Mortgage Alert, as of June For this reason and several others, CMBS market participants will sometimes conceptually bifurcate their thinking about loans (and deals) into two buckets: those loans underwritten before the credit crisis (aka, "CMBS 1.0" or "CMBS legacy") and those loans underwritten after the credit crisis (aka, "CMBS 2.0/3.0"). Clever names aside, the point here is that loan underwriting was often times too aggressive (i.e., borrower friendly) in 2006 and 2007, while it has generally been more conservative (i.e., lender friendly) post-crisis. Indeed, even the Barclays aggregate investment grade fixed income index includes separate components for each, called CMBS and CMBS 2, respectively. Using those indices as a guide, we estimate that approximately 76% of outstanding investment grade CMBS bonds are collateralized by CMBS 1.0 loans, with the remainder collateralized by CMBS 2.0/3.0. CIO WM Research 25 June

3 Where is the current value in CMBS? With volatility continuing its downward trend, combined with the continued investor need for yield, most fixed income spread products -- particularly investment grade corporates -- are at or near pre-crisis levels. Although the CMBS market has also witnessed a large spread tightening to Treasuries, they have lagged behind the tightening seen in investment grade corporates. This is relatively unusual since both spreads tend to move together. Moreover, as the economy has shown increasing signs of improvement over the last five years, and volatility has continued its declining pattern, the credit curve has flattened significantly, meaning that credit spreads have tightened more for bonds with lower credit ratings. Although the credit curve flattening is particularly prominent within investment grade corporates, CMBS has mimicked the same pattern, albeit to a lesser degree, with lower-rated BBB in CMBS tightening 60bps year to date, versus only 4bps in AAA. In our opinion, this means that investors are not attractively compensated for taking on the additional credit risk. In fact, thanks to the seemingly relentless rally in corporate spreads, re-allocating from relatively short maturity corporate bonds into "CMBS legacy" bonds could involve the welcome combination of a reduction in duration, increase in credit quality and pickup in yield. Using Barclays index data as of 30 May 2014, the 3.5-year modified duration of the CMBS index is significantly shorter than the Barclays corporate index's 7-year duration. Versus the comparable duration Barclays 3-5 year investment grade corporate index, the CMBS index duration is only marginally shorter (i.e., 3.5-year versus 3.7-year), but the average credit rating of the CMBS index is AA1, four credit "notches" higher than the corporate index's A2. In addiiton, the yield to worst of 2.11% for CMBS picks up 24bps versus the comparable duration corporate index. Benefits in rising rate environment Looking forward, the UBS CIO WMR economic outlook is for a robust recovery that bodes well for credit products, particularly visà-vis interest rate sensitive products. Thus, we expect the fundamental backdrop to be consistent with the expectation for CMBS to perform well. For those investors concerned about the flatness of the credit curve, both in CMBS and investment grade corporates not to mention high yield corporate spreads the implicit trade up in credit quality may offer a secondary benefit, namely a reduction in the sensitivity of spreads to a rising rate environment. Should interest rate rise as we expect, spreads lower down the credit stack may suffer worse (e.g., BBB spreads more so than AAA spreads). Fig. 3: Spreads tighter, credit curve flatter AAA spread (bps) Apr-12 Jun-12 Aug-12 Oct-12 AAA spreads Dec-12 Feb-13 Apr-13 Jun-13 Aug-13 Credit curve Oct-13 Dec-13 Feb-14 Apr Source: Bloomberg, as of June Note: AAA spreads are super senior versus 10-year USD swaps. Fig. 4: Yield pickup versus corporate bonds Yield to worst (%) Jan-13 CMBS index Corporate index YTW basis Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Source: Barclays, as of June Note: Yields for Barclays CMBS index and Corporate 3-5 year index, respectively. Fig. 5: CMBS relative value Issue CMBS Relative Value Spread New Issue Competing Differentials AAA 3Yr - AAA/AA 1-3Yr Corporate +37 AAA 5Yr - AAA/AA 3-7Yr Corporate +20 AAA 10Yr - AAA/AA 7-10Yr Corporate +14 Legacy Competing Differentials 2005 LCF - A 1-3Yr Corporate LCF - A 1-3Yr Corporate LCF - A 3-7Yr Corporate LCF - BBB 3-7Yr Corporate -7 Source: UBS CIO WMR, as of June 2014 Apr-14 May AAA / BBB credit curve (bps) CMBS - Corporate basis (bps) Hence, not only should CMBS give investors more comfort in terms of the trade up in credit quality, but it may also provide greater protection from rising rates. Finally, for anyone wondering why we would recommend the CMBS collateralized by loans underwritten during the "CMBS 1.0" days (i.e., when standards were relatively weak), the reasoning is pretty straightforward: only the strongest loans survived those times, so by now it's pretty fair to say that the collateral that remains is relatively robust and well known. CIO WM Research 25 June

4 Please note that our incremental preference for legacy type bonds does not imply that we're somehow not fond of CMBS 2.0/3.0 deals. Given the choice, however, we would generally prefer the deals collateralized by the legacy loans that survived the dark days. It may not always be easy for individual investors to source individual CMBS securities, however, we believe that a diversified exposure to the broad CMBS market (e.g., through an ETF) is an attractive alternative to positions in investment grade corporates. CIO WM Research 25 June

5 "B" Pieces: A term applied to the classes or tranches of CMBS rated double-b and lower. Also called B.I.G., or below-investment grade. Balloon Mortgage: A mortgage requiring monthly payments of principal and interest in which the period over which the loan is amortized is greater than the term of the mortgage. Principal and interest payments are made until maturity of the mortgage, at which time full payment of the remaining principal, the balloon payment, is due. For example, a seven-year balloon mortgage, with scheduled payments to amortize the loan in 30 years, will see part (but not all) of the principal paid down through year seven, at maturity. Basis Risk: The risk that the cash flow from the underlying mortgage loans does not mirror the required payouts to bondholders because the offered certificates are tied to different indices than are the mortgages (e.g., mortgages are at fixed rates but bonds are at floating rates). This raises the possibility of the certificates accruing interest at higher interest rates than the underlying mortgage loans. Call Protection: Protection against early prepayment of mortgages. If mortgages prepay early, then the bonds collateralized by those mortgages would be called or paid down, thereby affecting the total yield on the original bonds. Cash Flow: Cash flow is examined at the level of both the security and the individual property. At the security level, the certificate holders of CMBS receive all principal and interest cash flow from a pool of mortgages in a sequential, defined manner. Early prepayments or extended maturities change those cash flows and therefore can have a material effect on how and when some certificate holders receive their sequential payments, hence affect the total yield on the bonds. The cash flow on a CMBS is thus unlike that in the direct commercial mortgage market, wherein the cash flow contract is divided between receipt of principal payments and interest payments. In assembling the assets in a CMBS, the cash flow of an individual property is carefully scrutinized to calculate the ability of the property to generate sufficient revenue to service the debt that is in effect the collateral for the security. Commercial Mortgage Backed Security (CMBS): Securities collateralized by a pool of mortgages on commercial real estate in which all principal and interest from the mortgages flow to certificate holders in a defined sequence or manner. Commercial Property: An income-producing property, e.g., multifamily housing, retail, office, warehouse, industrial or hotel. Conduit: The financial intermediary that functions as a link, or conduit, between the lender(s) originating loans and the ultimate investor(s). The conduit makes loans or purchases loans from third party correspondents under standardized terms, underwriting and documents and then, when sufficient volume has been accumulated, pools the loans for sale to investors in the CMBS market. Also see Real Estate Mortgage Investment Conduit (REMIC). Credit Enhancement: Provisions in addition to the mortgage collateral to support a desired credit rating on mortgage backed securities. Provisions made by issuers to compensate for default risk in CMBS include subordination, reserve accounts, cross-collateralization, cross-default provisions, and advance payment agreements. Cross-Collateralization: A provision in a mortgage or deed of trust by which the collateral for one mortgage also serves as collateral for other mortgage(s). Thus, should the collateral on the one mortgage fall short in repayment of the debt, the collateral of the other mortgage(s) could be claimed as well (but only in the event of such a shortfall). CMBS backed by cross-collateralized properties have reduced delinquency risk; cross-collateralization therefore adds value to the structure. A set of properties with the same owner might be both cross-defaulted and crosscollateralized. A form of credit enhancement. CIO WM Research 25 June

6 Debt Service: The scheduled payments due on a loan. Payments include principal, interest and other fees that are required by the loan agreement. Debt Service Coverage Ratio (DSCR): A measure of a mortgaged property s ability to cover monthly debt service payments, defined as the ratio of net operating income or net operating cash flow to the debt service payments. A DSCR less than 1.0 means that there is insufficient cash flow by the property to cover debt payments. Delinquency: A loan payment that is at least 30 days past due. Usually when the loan is more than 90 days delinquent, the lender has the right to begin foreclosure proceedings. Employee Retirement Income Security Act of 1974 (ERISA): Legislation which stipulates the standards of risk that are appropriate and acceptable for private pension plan investments. A fiduciary of an employee benefit plan, i.e., a pension fund subject to ERISA, may invest in CMBS only if the certificates meet specified investment guidelines. Investment Grade: Investments that are rated triple-a, double-a, single-a and triple-b are investment grade, therefore appropriate for regulated institutional investors. Also see A pieces and Senior Pieces. Loan-to-Value Ratio (LTV): Briefly, the ratio of the loan amount to the appraised value of the property. More specifically, LTV is the ratio between the principal amount of the mortgage balance, at origination or thereafter, and the current value of the underlying real estate collateral. The ratio is commonly expressed to a potential borrower as the percentage of value a lending institution is willing to finance. The ratio is not fixed and varies by lending institution, property type, geographic location, property size and other potential variables. Lock-Out Period: A period of time after the loan origination during which a borrower cannot prepay the mortgage loan. Loss Severity: Rate of loss on a liquidated mortgage. Defined as the ratio of (a) the outstanding principal on the mortgage loans minus the realized loss, divided by (b) the outstanding principal on the mortgage loans. Net Operating Cash Flow (NOCF): The revenues earned by a property s on-going operations less the expenses associated with such operations and the capital costs of tenant improvements, leasing commissions and capital replacements costs (or reserves). Briefly, NOCF is net operating income less tenant improvements (TI s), leasing commissions and capital repairs. Net Operating Income (NOI): Total income less operating expenses and adjustments but before mortgage payments, tenant improvements, replacement reserves and leasing commissions. NOI is commonly used as a basis for many financial calculations, e.g., debt service coverage ratios. Option Adjusted Spreads (OAS): A representation of the incremental return (or risk premium) over comparable Treasuries (as a risk-free base) that incorporates interest rate volatility and possible variations in cash flow due to changes in rates. OAS does not, however, factor in credit quality. The technique was first applied to residential mortgage backed securities (MBS) to price the prepayment risk an investor assumes in residential MBS. In residential MBS, borrowers have a legal option to pay off their loans when interest rates decline, thereby creating reinvestment risk and possibly causing a reinvestment loss for the investor. This option is significantly reduced in CMBS, however, due to commonly used prepayment penalties. Overcollateralization: The outstanding collateral principal of a security in excess of the outstanding certificate principal. A form of credit enhancement. CIO WM Research 25 June

7 Prepayment: A whole or partial prepayment by the borrower greater than and/or earlier than a scheduled payment on a mortgage loan. Estimating the probability or scale of prepayments in a pool of mortgages is one of the more problematic risks in assessing the ultimate yield on the security or any class in the security. Prepayment Premium or Prepayment Penalty: A stipulation in loan documents requiring a borrower to pay a penalty for any prepayments made on a mortgage loan. Some prepayment premiums are structured as yield to maintenance. Other prepayment premiums are set at a fixed rate, which often decreases in steps as the loan matures. For example, a mortgage loan might have a prepayment premium of 5% for the first seven years, which decreases at a rate of 1% per year over the next five years (4% in year eight, 3% in year nine, etc.), so that after year twelve there is no prepayment premium. Prepayment Risk: The risk that a borrower will repay the remaining principal or an amount other than the scheduled payment on a mortgage prior to maturity, thus shortening the life of the loan. In order to reduce prepayment risk, commercial mortgages commonly have lockout periods, prepayment premiums and/or yield maintenance. Prospectus: The document filed with the Securities and Exchange Commission (SEC) that stipulates all the material information about a security. The final prospectus is commonly called the black to differentiate it from the preliminary prospectus which had been distinguished by red lettering on the cover to avoid confusion between the preliminary and final prospectus. In the case of a CMBS, the prospectus lists various details, including (but not limited to) the properties collateralizing the security, the terms and conditions of payment to security holders, the payment sequence among classes, the contingency plan in the event that mortgages are not paid as expected, and the treatment of defaults and prepayments. ALL relevant information about a security MUST be spelled out in the prospectus. Also see red herring. Real Estate Investment Trust (REIT): A legislated tax election option which allows a corporation or partnership specially formed to invest in real estate (e.g., by acquiring or providing financing for real estate properties) and/or securities backed by real estate. REITs are required to pass through 95% of taxable income to their investors but are not taxed at the corporate level. The major types of REITs are equity, mortgage, and hybrid; equity REITs are the most common. Refinance Risk: The risk that borrowers are unable to refinance mortgages at maturity, thereby extending the life of a security collateralized by those mortgages. Securitization: A term used to describe the process of raising funds through the sale of securities. It usually creates a new financial instrument representing an undivided interest in a segregated pool of assets such as commercial mortgages. The ownership of the assets is usually transferred to a legal trust or special purpose, bankruptcy remote corporation to protect the interests of the security holders. Senior Pieces: Security classes, or tranches, that are rated as investment grade, therefore appropriate for regulated institutional investors (i.e., triple-a, double-a, single-a, and triple-b). Also called A pieces. Senior/Subordinate Structure: A common structure used in CMBS involving a prioritization of cash flows. For example, in a simple two class senior/subordinate structure (also known as an A/B structure), (a) Class A will receive all cash flow up to the required scheduled interest and principal payment; (b) The subordinate class, Class B, provides credit enhancement to Class A, and (c) Class B will absorb 100% of losses experienced on the collateral until cumulative losses exceed Class B s amount; thereafter Class A will absorb all losses. Also known as a sequential pay structure. CIO WM Research 25 June

8 Special Purpose Entity (SPE): A bankruptcy-remote entity established by the borrower(s) at the loan level and the issuer at the securities level whose sole asset is the property or properties being financed. The SPC protects the lender and, ultimately, the certificate holders of a security, from having the underlying property involved in bankruptcy proceedings against the borrower on the property; in the event of a bankruptcy or insolvency of the borrower or issuer, an automatic stay would apply and delay payments to investors. Rating agencies generally request counsel to provide true sale opinions on the sale from the transferor to the issuer and non-consolidation opinions confirming that the entity is indeed bankruptcy remote. Also known as Special Purpose Vehicle (SPV). Structure: Refers to the tax and legal structure of a CMBS, such as pass-through structure, a bond structure, a collateralized mortgage obligation (CMO), or a real estate mortgage investment conduit (REMIC). The structure can determine the tax benefits or penalties, and the rights of the CMBS holders and the issuer in the event of a failure or default within the terms of the security. Most CMBS are senior/subordinated, multiple class passthroughs classified as REMICs. Structuring: The process of experimenting with various combinations of mortgages and security classes to achieve the highest price for a CMBS based on capital market factors prevailing at that time. Subordination: Structuring a security into classes, in which the risk of credit loss is disproportionately distributed. It is commonly recognized as a senior/subordinate structure. A form of credit enhancement. Tranche: A term applied to describe the discretely-rated classes of CMBS securities, e.g., the triple-a tranche. Each class or tranche is typically paid a coupon stipulated at the time of issue and principal based on a predetermined payment sequence. Typically, lower-rated tranches have higher coupons and longer lives, since they receive interest payments (the coupon) but no principal payments until the higher-rated tranches have been retired or paid off. Waterfall: A term used to describe the cash flow pay-out priority of a CMBS. The cash flow from the pool of mortgages typically pays principal plus interest to the highest rated tranche, while paying only interest on the lower-rated tranches (the coupon payment having been stipulated at the time of issue). After all of the certificates from the highest-rated tranche have been retired or paid down, the cash flow then is dedicated to paying principal as well as interest to the next-highest rated tranche. While all tranches receive interest or coupon payments, principal is paid to each tranche in sequence until each successively-rated tranche is paid down, in accord with the sequence stipulated in the prospectus at the time of issue. Since lower-rated tranches receive principal payments only after higher-rated tranches are paid down, they typically have longer average lives, i.e. are paid off later. The waterfall analogy refers to the visual image of a champagne waterfall, in which the flow of champagne/cash first fills up the highest tier/triple-a bucket, then spills into the next tier/double-a bucket, then the next tier/single-a bucket, etc. CIO WM Research 25 June

9 Appendix Chief Investment Office (CIO) Wealth Management (WM) Research is published by UBS Wealth Management and UBS Wealth Management Americas, Business Divisions of UBS AG (UBS) or an affiliate thereof. CIO WM Research reports published outside the US are branded as Chief Investment Office WM. In certain countries UBS AG is referred to as UBS SA. This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein does not constitute a personal recommendation or take into account the particular investment objectives, investment strategies, financial situation and needs of any specific recipient. It is based on numerous assumptions. Different assumptions could result in materially different results. We recommend that you obtain financial and/or tax advice as to the implications (including tax) of investing in the manner described or in any of the products mentioned herein. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/ or may not be eligible for sale to all investors. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS and its affiliates). All information and opinions as well as any prices indicated are currently only as of the date of this report, and are subject to change without notice. Opinions expressed herein may differ or be contrary to those expressed by other business are as or divisions of UBS as a result of using different assumptions and/or criteria. At any time, investment decisions (including whether to buy, sell or hold securities) made by UBS AG, its affiliates, subsidiaries and employees may differ from or be contrary to the opinions expressed in UBS research publications. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to control the flow of information contained in one or more are as within UBS, into other areas, units, divisions or affiliates of UBS. Futures and options trading is considered risky. Past performance of an investment is no guarantee for its future performance. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in FX rates may have an adverse effect on the price, value or income of an investment. This report is for distribution only under such circumstances as may be permitted by applicable law. Distributed to US personsby UBS Financial Services Inc., a subsidiary of UBS AG. UBS Securities LLC is a subsidiary of UBS AG and an affiliate of UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-us affiliate when it distributes reports to US persons. All transactions by a US person in the securities mentioned in this report should be effected through ausregistered broker dealer affiliated with UBS, and not through a non-us affiliate. The contents of this report have not been and will not be approved by any securities or investment authority in the United States or elsewhere. UBS specifically prohibits the redistribution or reproduction of this material in whole or in part without the prior written permission of UBS and UBS accepts no liability whatsoever forthe actions of third parties in this respect. Version as per May UBS specifically prohibits the redistribution or reproduction of this material in whole or in part without the prior written permission of UBS and UBS accepts no liability whatsoever forthe actions of third parties in this respect. UBS The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. CIO WM Research 25 June