Pullback By Regional Banks Exposes Widest Spreads In Years

As money managers worry that regional US banks will fail due to a blowup, these bonds are getting punished by financial institutions. However, investors such as GMO Securities say there is a good deal to be found for those who will carefully vet the securities before investing.

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During the first half of the year, commercial mortgage bonds with the highest credit ratings had risk premiums, or spreads, averaging 1.12 percentage points, which was near the highest level since the onset of the pandemic early last year and before then, near its highest level since 2016.

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A large number of commercial real estate debts are expected to mature by the year 2025, and money managers are concerned that the situation could make refinancing some of these loans difficult, particularly since a number of regional lenders, such as Silicon Valley Bank and Signature Bank, failed to lend to commercial real estate. Goldman Sachs Group Inc. economists report that regional banks represent about 80% of all lending to commercial properties. However, GMO and Sun Life's institutional asset management division say the panic in commercial mortgage-backed securities has spread too far, with bonds now available at an affordable price that can withstand even a severe recession.

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CMBS investors are going to benefit from low-interest rates and an improvement in asset quality, according to Daniel Lucey, portfolio manager at SLC Management, which is an arm of financial services firm Sun Life.

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A recent GMO research note indicates that top-rated CMBS typically have 30% credit support, so bond investors would only be hit by a loss of 30% of the underlying loan portfolio before being impacted. According to the authors, "the most aggressively underwritten" CMBS portfolios only ever experienced losses of around 11% before the 2008 financial crisis.

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In addition to looking cheap, CMBS bond spreads are near their widest since 2011. In comparison with corporate bonds, longer-dated CMBS has spreads that are much wider today. For much of that period, longer-dated CMBS spreads were tighter than corporate bonds, but now they are larger.

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Depending on your perspective, these relative values may represent a buying opportunity to you, particularly if you think the underlying property is in good shape.

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According to Joe Auth, lead portfolio manager at GMO, the asset manager co-founded by Jeremy Grantham, the top bond in a CMBS capital structure has incredible protection against even the worst of scenarios.

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A recent research report by Bank of America's Alan Todd recommended neutral allocations to some types of top-rated CMBS, up from underweight. The spreads were driving the market higher because of concerns over the nation's banking system, which caused a spike in volatility.

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"The main driver behind the financial crisis was the concern that unmitigated stress would cause problems in the banking system, and that's now abating somewhat, partly as a result of quick intervention by regulators like the Federal Deposit Insurance Corp., which took over failed banks,” Todd explained.

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