CMBS Opportunities Still Exist, Despite the Rally

CRE Finance World, Summer 2012

CMBS Opportunities Still Exist, Despite the Rally Jeffrey Berenbaum Rajashri (Priya) Joshi Director Director Citi Citi T mid-April in response to re-emerging Eurozone and MLIII full-scale market meltdown. We put the probability of this scenarioa probability of 60% to this scenario. A second scenario, “StabilityReturns,” assumes an expedited resolution of the Eurozone crisis anda return to pre-crisis levels for the VIX. We put a 35% probabilityon this scenario. A third scenario, “Liquidity Crisis II,” envisions ahe apparent stabilization in the global macro backdropthat has emerged this year has led CMBS spreads tighteracross the capital stack (Figure 1). Although the spreadtightening has not been linear (spreads widened out in concerns), most CMBS sectors are still tight to their yearend 2011 at just 5%. levels. As of the end of April, generic 2007-vintage dupers, GG10 dupers, and CMBS 2.0 triple-Bs are 50–70bp tight to yearend, Figure 1 shows that spread levels on most CMBS sectors are, as while 2007 AMs are more than 200bp tight to their yearend level. of April 2012, inside of our “Vol Persists” targets, with a few even Even some of the least risky CMBS sectors, including Fannie Mae approaching our “Stability Returns” targets. CMBS 2.0 BBB is 10/9.5 DUS and CMBS 2.0 naturally rated triple-As, are 10–20bp the only major CMBS sector that is still wide of its “Vol Persists” tight to their yearend 2011 levels. Meanwhile, dollar prices on generic target. Still, there is room for CMBS spreads to rally. For one thing, 2006- and 2007-vintage AJs are up significantly since yearend. spreads are still attractive to competing sectors, including corporates and credit card ABS. Another factor that makes CMBS compelling Figure 1 versus unsecured alternatives is that corporate bonds’ “reactivity CMBS Credit Spread Curve (Yearend 2011, April Month End) advantage” (as discussed below) has diminished. Finally, within the and 2012 Spread Targets CMBS space, intra-vintage tiering continues to present opportunities. Most Sectors are in Line With Vol-Implied Levels While the CMBS market has tightened more than expected this year, spreads on most sectors are actually in the ballpark of where they should be based on current subdued levels of market volatility. Our spread target methodology has two ingredients: 1. The reactivity of CMBS spreads to the VIX. CMBS reactivity to the VIX (swap spread divided by the VIX) remains elevated compared to the pre-crisis level. We do not foresee that sensitivity permanently declining any time soon. Therefore, both the “Vol Persists” and “Stability Returns” scenarios assume that CMBS spreads sensitivity remains in its post-crisis range. 2. The level of the VIX itself. We formulated our “Vol Persists” targets based on the assumption that the VIX would remain Source: Citi Investment Research and Analysis in its 2011 average area (mid-20s) and assigned this scenario a 60% probability. But our “Stability Returns” targets assume Does the rally mean that the sector is rich again? Or will investors that the VIX retreats to well below the 2011 average, and we still have the opportunity to find value in the second half of the year? assigned this scenario a 35% probability. We think that the sector still offers good relative value. CMBS spreads are not overpriced, in our view — in fact spreads are right The VIX sensitivity of most CMBS sectors has indeed remained in around where we would expect them to be, based on the level of its 2011 range so far this year, as we expected. But volatility has volatility in broader markets. declined much sooner and faster than we thought it would. The VIX briefly rose above 20 in mid-April in response to the re-emergence Because CMBS spreads have become increasingly correlated to of Eurozone concerns, but has since retreated back to the 16–17 broader market volatility, at the beginning of the year we developed area, which is between the levels that we assumed in formulating spread targets based on the level of the VIX.1 One scenario, which our “Vol Persists” targets (24) and “Stability Returns” targets we called “Vol Persists,” assumes that the VIX remains in its elevated (around 14). So, unsurprisingly, spreads have tightened inside of 2011 range, with Eurozone uncertainty and domestic macro our “Vol Persists” targets and are even approaching the “Stability concerns continuing to weigh heavily on the market. We assigned Returns” targets in a few cases. CRE Finance World Summer 2012 44


CRE Finance World, Summer 2012
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