Office Fear, Fed Keep Buyers of Lower-Rated Commercial Mortgage Bonds On Sidelines

(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.

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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.

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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.”