(Bloomberg) -- Spreads on lower-rated commercial mortgage-backed securities widened over the summer as traditional buyers of the debt wait for more clarity on the outlook for interest rates and office valuations. 

Spreads on CMBS bonds rated BBB- have widened by nearly 150 basis points to almost 1,100 basis points or 11 percentage points since April, while higher rated CMBS bonds — as well as investment-grade and high-yield corporate bonds — have stayed flat or tightened slightly, according to data a Deutsche Bank AG research note this week. 

CMBS are bonds backed by loans that corporate borrowers take out by using real estate properties as collateral. In recent months there have been few buyers for what’s often the lowest-rated such bond available for purchase, helping push the spreads on debt rated BBB-, one notch above junk, higher as key questions about interest rate hikes and office valuations remain unanswered, according to CMBS traders and analysts. 

In one sign of that demand shortfall, more issuers are retaining or pre-placing BBB rated portions of the deals, according to Anuj Jain, an analyst at Barclays Plc. 

Investors are “stuck in no man’s land” until the Federal Reserve stops raising interest rates, said Paul Norris, head of structured products at Conning & Co. They’re hesitant to buy the 10-year bonds that traditionally comprise much of CMBS issuance, especially conduits, which are backed by multiple kinds of real estate properties, including malls and offices, he said. That’s because of the fear that interest rates will only continue rising, which would erode the price of bonds purchased today, Norris said. 

Once the interest rate hikes are done, that will change, he said. “As soon as the market gets the sense that the Fed is done and they’re going to stop hiking for sure, everyone is going to flock to 10-year CMBS.”  

Earlier this week the Federal Reserve left its benchmark interest rate unchanged but signaled borrowing costs will likely stay higher for longer after one more hike this year. Not all Fed officials agree on the exact path forward, which depends on evolving inflation and unemployment data. 

However, it isn’t just uncertainty about the Fed that’s keeping wary buyers on the sidelines. Two-and-a-half years after the Covid-19 pandemic caused a sea change in work-from-home culture, the market price of office buildings, especially older buildings, is still unclear. 

“The credit issues being faced at the bottom of the CMBS capital stack are very tied to office,” said Jane Rivers, a CMBS trader at T Rowe Price. “The sentiment around office has only gotten worse over the past year.” 

Some caution about not reading too deeply into the pricing data for BBB and BBB- rated CMBS. A side effect of more buyers staying on the sidelines and fewer issuers offering the lowest rated debt is less liquidity and worse price discovery, according to Paul Staples, a CMBS trader at Academy Securities Inc. 

For now, it remains unclear when wary CMBS investors will get more clarity on interest rates and office valuations. Still, to investors like Norris it’s only a matter of time until there are some answers, and when that happens CMBS could turn into hot commodities. 

“Spreads could go wider, which they probably will, but at some point CMBS conduit is going to be really attractive,” said Norris. “I think there’s going to be some great opportunities to buy CMBS.” 

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Relative Value

For commercial real estate and other sectors that rely heavily on leverage, the Fed’s “higher-for-even-longer” narrative may finally force rate considerations into asset valuations, write Barclays analysts Lea Overby and Anuj Jain in a research note dated Sept. 21. 

  • “As the timing of lower rates continues to slip ever farther into the future while GDP growth remains fairly muted, we remain cautious on CMBS lending standards”
    • Though debt service coverage in most of these cases is still high and should be positive for performance, “we are biased towards up-in-quality CMBS positioning for new issuance”
  • Negative leverage remains quite high in CMBS, with the capitalization rate below the mortgage rate for a sizable portion of newly issued loans
    • In addition to other types of CRE, this is affecting stabilized loans, such as those found in conduits and agency CMBS
  • “For most of these loans, borrowers may believe in part that improved cash flow growth can make the deal more affordable over time, or they may believe that the opportunity to refinance into a lower coupon is just a few years away”

Spreads Change

What’s Next 

A new timeshare deal from Elara is premarketing, with announcement and pricing expected during the week of Sept. 25. An auto deal from the Oregon Community Credit Union is also premarketing and a presale report from S&P Global is out for an auto deal for the Ent Credit Union. Read more here. 

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