When commenting on 2012 performance last year, we noted that investors could really only have one complaint: why didn’t we own more? For investors to make money in 2013, they had to be more discriminating. While there were plenty of segments of the market that did well, there were also other segments that lagged severely.
Some of the many issues that investors had to deal with in 2013 were:
• The impending end (or tapering) of QE3
• Rising interest rates (after reaching a rate of about 1.6%, the 10-year Treasury ended 2013 hovering around 3%)
• Potential war in Syria
• The unraveling of the financial system in Cyprus
• A US government shutdown and the potential of a failure to reach a debt ceiling deal
All of these weighed on investors at one point or another, but none of them could stop the march of new issuance in 2013. The final issuance approached $90 billion, almost twice the total of 2012 and the best tally since 2007.
Of all the concerns that investors had to sift through, the biggest one impacting the CMBS market was the growing prepayment risk associated with legacy bonds. In this area, investors had to weigh two realities: legacy last cashflow bonds were rapidly approaching the period when many underlying loans would come out of lockout (particularly for 2004 and 2005 names) and special servicers were resolving troubled loans at a high rate, driven by the recovering values of the collateral. All of this helped put spreads on legacy super seniors sharply wider.
Overall, the CMBS market saw a nice rally from January through mid-May, just as it did in 2012. However, in another repeat of 2012, the market saw significant widening in late May through June. In 2012, it was concerns over the economy in Europe–particularly Greece and Spain–that put the market in a sour mood. In 2013, it was the concern that a reduction of the rate of bond purchases from $85 billion by the Federal Reserve would slam the brakes on the CMBS market. After a brief issuance pause in the early summer and a lot of hand-wringing from issuers, the rate of new issuance re-accelerated and CMBS spreads regained their footing. CMBS spreads, however, would never regain the lows of early May.
During that early May peak, the GSMS 2007-GG10 A4 bond hit a multi-year low of 115 basis points over swaps. Similarly, new issue 10-year AAA paper reached its tightest level (73 basis points over swaps) as did CMBS 3.0 BBB minus paper (310 basis points over swaps). The combination of historically low Treasury rates and tight CMBS spreads allowed many CMBS borrowers to refinance properties that would not have had a chance to do so three years ago.
AAA LCF Spreads Move Sharply Wider on Prepayment Risks
The average 2004 last cashflow AAA conduit bond opened the year at 66 basis points over swaps. By the end of 2013, the average spread was almost 200 basis points over swaps. Some of the bonds in this category have been retired and many others are “marching toward par.” With so much of the underlying collateral at or near the point at which it can prepay freely or with a small premium, investors are no longer willing to pay steep premium prices for these bonds.
The story was similar, if not as severe, for 2005 last cashflow AAA conduit bonds. The average 2004 last cashflow AAA conduit bond opened the year at 72 basis points over swaps. By the end of 2013, the average spread was almost 124 basis points over swaps. In many cases, the mezzanine AAA bond from 2005 and 2006 deals is trading at or inside the spread for the super senior bond (especially for those with strong underlying credit). In these cases, investors are valuing the additional prepayment protection being offered by the AM classes.
For 2006 and 2007 last cashflow AAA conduit bonds, there was also widening. The 2006 super seniors were off 43 basis points while 2007 bonds were off 31 basis points. The GSMS 2007-GG10 A4 bond, for example, opened the year at 137 basis points over swaps but closed 2013 at 169 basis points over swaps.
Nice Gains for AMs and AJs
While last cashflow AAAs were the laggards among legacy names, there were gains to be had among AM and AJ bonds. As the following table indicates, spreads on AM bonds were tighter by 22 to 97 basis points on average. Spreads on AJ bonds narrowed by 111 to 369 basis points on average.
As with AMs and AJs, mezzanine paper saw strong rallies particularly for deals with underlying collateral that was relatively clean and from earlier vintages. For 2006 and 2007 vintages, investors remained more discriminating. Certain mezzanine paper from the 2006 vintage (and to a lesser extent 2007) saw meaningful price gains if the underlying collateral was solid. However, much of the mezzanine and credit tranches backed by dented collateral from the 2006 and 2007 vintages remain in the deeply discounted bin.
CMBS 3.0 Experiences Ups and Downs
The story for investors in CMBS 3.0 bonds was similar to the experiences for legacy investors. For buyers of long AAAs, there was modest spread widening from the end of 2012 to the end of 2013. For investors further down the curve, there were modest gains year over year.
For those that see the glass as half empty, 2013 was the year of “what might have been.” New issue 10-year paper ended the year at swaps plus 93 basis points, but spreads on new issue LCFs were as tight as S+72 early in 2013. Even more stark were the BBB- bonds. The BBB- tranches ended the year about 390 to 400 basis points over swaps, but at one point in May 2013, those bonds were being priced around 310 to 320 basis points over swaps.
For those that see the glass as half full, there could have been severe losses across the board. During the mid-summer swoon, new issue 10-year AAA paper got as wide as S+128 while new issue BBB minus was in the S+450-475 range around the same time. The final scorecard, however, paralleled the results for legacy paper: modest losses at the top of the stack and small gains lower down the credit curve.
The Good, the Bad, and the Ugly
A year in review would be incomplete without the annual Good, Bad, and Ugly. Below are the high and low lights from the year. Some common themes were Fed taper talk, recovering collateral values, and a few more retail chains’ struggles.
• January: Tax deal sends CMBS spreads tighter to start new year, CMBS 2.0/3.0 goes on a tear.
• February: KKR buys Legends at Village West retail property and RXR buys 237 Park Avenue.
• (Early) May: Legacy mezzanine bonds on fire as investors reach for yield.
• (Early) May: GSMS 2007-GG10 bond hits lowest spread since 2008.
• December: Final CMBS delinquency rate hits 7.43% – almost 3 points below all-time peak 17 months earlier.
• December: Final CMBS new issuance total nearly doubles 2012 tally, which is the highest level since 2007.
• March: 2007 deal becomes first conduit to see super seniors hit with shortfall (MSC 2007-HQ13).
• (Late) May: CMBS market sells off sharply on concerns over Fed tapering, AJs crushed.
• June: Fear envelopes CMBS market over Fed tapering worries.
• July: Epic losses hammer 2007 deal. Losses wipe out 11% of AJ class – $310 million in losses across 21 loans (LBUBS 2007-C2).
• July: The $118.7 million Silver City Galleria loan is liquidated with a loss of $111 million.
• September: Worries over government shutdown puts traders on edge.
• February: Maryland office loan Metro I Building liquidated with 100% loss.
• February: Blizzard shuts down financial markets. $128 million Renaissance Tower Office Building Loan Restructure with 50-50 A Note/Hope Note split.
• July: $118.7 million Silver City Galleria loan liquidated with loss of $111 million.
• August: Drumbeats of war over Spyria spook traders.
• October: Concerns over J.C. Penney’s condition sends investors searching for JCP exposure. The $109.4 million Granite Run Mall loan takes $102 million loss.
• November: Three CMBS deals are impacted when the modification is finalized for the $678 million Skyline Portfolio (Virginia).
• December: Discount retailer Loehmann’s announces plans to liquidate.
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