Left out of Fed action, lower-rated CMBS overheat

The Federal Reserve purchased $5.5 billion of agency commercial mortgage-backed securities (CMBS) over the 11 days to April 7, helping rein in runaway yields on the structured products. But the central bank’s refusal to buy private label securities has caused those flirting with junk status to rapidly lose value.

In March, yields on CMBS issued by Fannie Mae, Freddie Mac and Ginnie Mae surged upwards in tandem with non-agency securities as the coronavirus crisis raged, Bloomberg Barclays CMBS indexes show. The agency-only index shows yield-to-worst jumped 90 basis points between March 9-24 to 2.1%, while the non-agency index spiked 200bp to 3.9%.

 

 

The Fed announced it would buy up agency CMBS on March 23 and opened its market operations with a $1 billion buying spree on March 27. In response, between March 24 - April 7 agency-only yields fell 60bp to 1.5%. Non-agency CMBS yields have also come in 90bp, but remain elevated at 3%.

Within the private sector CMBS universe, yields on low investment-grade securities have continued to spiral as higher-quality bonds have recovered. The BBB index yield-to-worst was 8.6% on April 7, up from 3.5% on March 5. The AAA index, in contrast, stood at 2.2% on April 7, up from 1.5%.

 

What is it?

The Bloomberg Barclays CMBS family of total return indexes aggregate dollar-denominated securities by credit quality. Only deals over $300 million are included. They are commonly used as benchmarks by exchange-traded funds (ETFs), like the iShares US CMBS ETF.

As asset-backed securities feature prepayment provisions that can be exercised by the issuer, the indexes eschew yield-to-maturity in favour of “yield-to-worst” – the yield to the earliest possible redemption date.

Why it matters

The Fed has sought to sedate markets turned wild by the coronavirus pandemic, but there are some corners it still won’t venture into. The market for private label CMBS is one such unfortunate. Trade bodies have protested their exclusion from the central bank’s Term Asset-Backed Securities Loan Facility (TALF), but so far their pleas have fallen on deaf ears.

When investors scent weakness in a market, they target the most vulnerable – in the case of CMBS, low-rated tranches. High-quality CMBS may be recovering in part because of the balm applied by the US government’s rescue measures, but this can only offer stop-gap relief to CMBS that were already of shaky credit. This dynamic likely explains why BBB mortgage bonds have continued to plummet.    

If these securities are downgraded, it may force some funds with mandates that forbid the holding of junk bonds to sell them off all at the same time, causing yields to jump even higher.

Correction, April 9, 2020: This article has been amended to correct the basis point change in the yield-to-worst for the agency and non-agency CMBS indexes.

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