Download What are commercial mortgage-backed securities?

Investment Insights
Kevin Collins
Head of CMBS Credit
Invesco Fixed Income
Daniel Saylor
Senior Analyst
Invesco Fixed Income
What are US commercial mortgage-backed securities
(US CMBS)?
US Commercial mortgage-backed securities (US CMBS) are bonds collateralized by commercial
real estate loans which are, in turn, secured by commercial real estate. The cash flow from the
commercial mortgage loans is used to service the interest and repay the principal on the bonds.
Background
The US CMBS market began in the early 1990s after the US congress created the Resolution Trust
Corporation (RTC) to resolve the savings and loan crisis.1 S&Ls were active in mortgage, consumer
and commercial lending but adopted risky lending practices that led to insolvency. The issuance of
CMBS helped the RTC dispose of non-performing and distressed commercial mortgage loans as it
liquidated failed S&Ls. The RTC paid discounted prices for the commercial mortgages, pooled them
together, and sold them in tranches to investors in the form of securities — CMBS.
Growth
Due to its success as an asset class, the US CMBS market continued to develop after the S&L crisis
was resolved. The value of US CMBS outstanding grew from USD42 billion in 1990 to approximately
USD900 billion by 2007.2 Since then, the size of the market has declined to USD565 billon, as loans
have been paid down and issuance slowed following the global financial crisis.3 However, origination
activity and corresponding US CMBS issuance has accelerated in recent years as investors have tried
to gain exposure to loans with lower current loan-to-value ratios (ratio of loan amount to property
value) and higher debt service coverage ratios than those originated pre-crisis.
Today
Today’s US CMBS market is an important sector in the global fixed income market. It enables a wide
range of investors to gain exposure to the US commercial real estate market and facilitates financing
to real estate owners across a wide range of property types. Today, the US CMBS sector is part of
the Barclays U.S. Aggregate Bond Index.
Why consider US CMBS?
A CMBS strategy can provide focused exposure to commercial real estate loans or help diversify an
overall fixed income portfolio. We believe interesting opportunities currently exist in US CMBS due to
strong US commercial real estate fundamentals and a growing number of US commercial real estate
loans that will need to be refinanced. Further, US CMBS may provide attractive incremental yield
relative to the US corporate bond market.
We believe institutional money managers, insurance companies, pension funds and other investors
may want to consider US CMBS for several reasons:
1 Historically provided incremental yield relative to the US corporate bond market
2 Limited prepayment risk due to prepayment penalties on underlying loans
3 Diversification across property types and US states
4 US CMBS are backed by loans secured by income-producing commercial real estate.
5 Focused exposure to an improving US economy and a US commercial real estate market that
has benefited from increased demand
1 The large scale failure of community savings and loans institutions, or “S&Ls.”
2 Commercial Mortgage Securities Association (CMSA), July 2007
3 SIFMA, Sept. 2016
This document is for Qualified Investors in Switzerland, Professional Clients in Continental Europe, Dubai, Guernsey, the Isle
of Man, Jersey and the UK; for Institutional Investors only in the United States and Australia; for Professional Investors in
Hong Kong; for Qualified Institutional Investors in Japan; for Persons who are not members of the public (as defined in the
Securities Act) in New Zealand; in Singapore for Institutional Investors and / or Accredited Investors; in Canada, this document
is restricted to Accredited Investors as defined under National Instrument 45-106. It is not intended for and should not be
distributed to, or relied upon by, the public or retail investors. Please do not redistribute this document.
US CMBS have provided incremental yield
(Yield on CMBS minus yield on comparably rated sector)
6/30/16
3/31/16
12/31/15
9/30/15
6/30/15
3/31/15
12/31/14
9/30/14
6/30/14
3/31/14
12/31/13
9/30/13
6/28/13
3/29/13
9/28/12
6/29/12
3/30/12
12/31/12
%
12/30/11
• Baa additional yield • A additional yield • Aa additional Yield
6
5
4
3
2
1
Source: Barclays, 31 Dec. 2011 to 30 June 2016. Barclays US CMBS 2.0 Aaa 8.5+ Year Index, Barclays US CMBS 2.0
Aa Year Index, Barclays US CMBS 2.0 A Year Index, Barclays US CMBS 2.0 Baa Year Index, Barclays Aaa Corporate Index,
Barclays Aa Corporate Index, Barclays A Corporate Index, Barclays Baa Corporate Index.
How does a US CMBS work?
US CMBS start with a pool of mortgage loans. The cash flow from this “collateral pool” of mortgage
loans is used to service interest and repay principal on US CMBS. Typical US CMBS capital structures
include multiple classes of bonds divided according to their level of expected risk and maturity. These
classes have different positions in terms of priority of receiving interest and principal payments. The
senior classes (lower credit risk) are scheduled to receive interest and principal payments ahead of
the junior classes (higher credit risk). Any collateral losses would typically be applied to the junior
classes first and distributed in order of junior to senior class. As such, the risk of not receiving
interest and principal payments on a given security is greater for the junior classes relative to the
senior classes.
Typical US CMBS Transaction
Investment Grade CMBS:
Aaa/AAA
Collateral
Pool
Last
Loss
Lower
Credit
Risk
Other Investment Grade CMBS:
Aa2/AA, A2/A, Baa2/BBB
Non-Investment Grade CMBS:
Ba2/BB, B2/B
Non-Rated CMBS
First
Loss
Higher
Credit
Risk
For illustrative purposes only
IFI approach to CMBS
Invesco Fixed Income (IFI) employs a balanced top-down, bottom-up risk allocation approach in our
portfolio construction process. Our top-down analysis examines factors in the broader US economy
such as GDP growth, interest rates, labor market dynamics, consumer data and corporate earnings.
Our analysis then defines fundamental trends in US commercial real estate such as property supply,
tenant demand, occupancy rates, rental rates and financing terms to shape our outlook for various
commercial real estate property types across geographic regions in the US. Our outlook for each
regional market and property type helps form key rent growth and valuation assumptions used in
our bottom-up analysis.
Investment Insights: What are US commercial mortgage-backed securities (CMBS)? 2
How IFI is different
While many investment managers rely on external credit ratings in making CMBS investment decisions,
IFI conducts a review of each credit. Our analysis considers insight from our macro team, direct real
estate investors, mortgage servicers and commercial real estate loan brokers in the US. The insights of
IFI’s corporate credit team are also utilized to monitor tenant risk, such as potential retail store closings.
Our proprietary model projects loan level defaults and corresponding loss severities for individual
loans underlying each security (i.e. “collateral performance”). Each loan is assigned a risk score
which considers trends in debt service coverage ratios, loan-to-value ratios, occupancy rates, and
payment histories. After projecting the performance of the underlying collateral, scenario analysis
is conducted to project bond and transaction cash flows under base, favorable and stress scenarios.
Each CMBS class is assigned a fundamental rating. These ratings are communicated across the
broader IFI team. Performance of collateral pools is monitored and ratings changes are broadcast
to the team. Relative value analysis compares internal ratings to projected yields to make buy and
sell decisions. Performance of individual securities is closely monitored and positions are typically
re-evaluated quarterly, using the most recent underlying property and loan cash flows.
We believe our seasoned investment team and robust research capabilities enable us to identify
attractive income opportunities and anticipate incremental credit spread tightening through
disciplined security selection and timely sector allocation.
CMBS assets under management across Invesco
December 2006 to June 2016
• CMBS AUM • CMBS investment grade index spread over US Treasuries
12/06
bps
12/07
12/08
12/09
12/10
12/11
12/12
12/13
12/14
12/15
USD mm
1,600
8,000
1,400
7,000
1,200
6,000
1,000
5,000
800
4,000
600
3,000
400
2,000
200
1,000
Source: Invesco Fixed Income and Barclays Live (Barclays CMBS Investment Grade Index, Barclays U.S. Treasury Index), data
from 31 Dec. 2006 to 30 June 2016.
Investment Insights: What are US commercial mortgage-backed securities (CMBS)? 3
Important information
This document is for Qualified Investors in Switzerland, Professional Clients in Continental Europe, Dubai, Guernsey, the Isle of Man, Jersey and the UK;
for Institutional Investors only in the United States and Australia; for Professional Investors in Hong Kong; for Qualified Institutional Investors in Japan;
for Persons who are not members of the public (as defined in the Securities Act) in New Zealand; in Singapore for Institutional Investors and / or Accredited
Investors; in Canada, this document is restricted to Accredited Investors as defined under National Instrument 45-106. It is not intended for and should not
be distributed to, or relied upon by, the public or retail investors. Please do not redistribute this document.
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II-CMBS-INSI-1-E 09/16 GL316