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Coming off a year of spread compression and positive excess returns, the outlook for securitized products remains nuanced amid several cross currents. However, the spreads and yields on high-quality securitized products remain attractive relative to comparable fixed-income instruments, setting up a promising year ahead for long-term investors who can sift through the sector’s dispersion to identify its ample alpha-generating opportunities.
There has been no shortage of headlines around the challenges in the commercial real estate market. Offices have come under the most scrutiny, with headwinds from the rapid rise in interest rates and the work-from-home era converging. Valuations across the CRE spectrum have declined, financing has become scarce, and transaction volumes have fallen. But despite the likelihood of losses in the CRE market, recent trends have created fertile ground for investment opportunities. Lower valuations have made high-quality CMBS attractive, particularly for those with a long-term perspective.
Higher interest rates have a cascading impact on the CRE market. As rates rise, property owners with floating-rate debt must meet higher financing costs, and some borrowers will find that their properties won’t generate enough cash flow to cover financing costs. Purchase prices for new capital investments must therefore be adjusted lower for owners to achieve target returns. Fixed-rate borrowers may be better positioned, but lower valuations and weakening fundamentals still pose refinancing challenges.
An uncertain outlook may help make the case for an allocation toward high-quality CMBS, particularly in senior tranches that hold the potential for relatively attractive risk-adjusted returns with robust structural credit protection. It is also important to note that the office sector, which has no doubt faced intense pressure given the shift to remote work, is just one piece of the CRE pie. Office loans account for approximately 16% of total CRE mortgage debt outstanding.1
The strain in the office sector has pressured more defensive corners of the CMBS capital structure, thus raising the value proposition for fixed-income investors.
There is value emerging within conduit AAA securities, where spreads have been wider than those of the IG Corporate Index for the first time since the Global Financial Crisis. These high-quality, diversified conduit securities are poised to benefit from credit stress in the underlying pool of CRE loans. Even in a default scenario, investors can capture upside in price, given that these bonds have been trading at discounts to par due to elevated rates.
Conduit AAA vs IG Corporates Basis
Source: PGIM Fixed Income, JPM Indices, Bloomberg Index as of January 10, 2024
While conduit loans are generally weaker than those from balance sheet lenders, these securities are structurally insulated from credit and extension risk because of their significant credit enhancement and payment priority within the deal waterfall.
Investors with the capabilities to perform rigorous bottom-up underwriting can also find opportunities further down the capital structure. Significant repricing has created value within certain single asset, single borrower (SASB) securities, which allow investors to target specific sectors and assets. Investors can capture this value through selective exposure to mezzanine and subordinate tranches of trophy assets that have been priced to worst-case scenarios.
The current environment presents an array of challenges for the CRE market. The effects of higher rates and tighter credit conditions are set to play out slowly given the nature of multi-year leases across the office, retail and industrial sectors. In the industrial and multifamily sectors, loans originated at peak valuations will likely struggle to refinance, and mezzanine tranches could be at risk of principal losses in the event of further price erosion. Price volatility, distressed workouts and market negativity may very well continue to afflict the CRE market as borrowers approach looming maturity walls.
Although this backdrop has cast a shadow over commercial real estate, bargains are emerging across the CMBS capital structure — even in the office sector, where pockets of value are developing within select properties and markets that are expected to survive the current cycle. Meanwhile, fundamentals in the industrial and multi-family sectors are generally sound, banks will be incentivized to extend and amend distressed loans, and onshoring policies and industrial spending may help offset a potential lull in new construction.
Headwinds in the CLO market will likely remain amid weaker credit fundamentals, even as low supply and strong demand from new issuance provide technical support for underlying loans. Investors can also expect an increase in CCCs, as a higher-for-longer rate environment weighs on floating-rate loan borrowers. Although CLO mezzanine tranches have widened, they have yet to account for potential loan losses. A better entry point remains further down the road. In the meantime, AAA and AA CLOs in the US and Europe stand out as attractive investments.
Having a tactical approach will also prove useful when navigating the market for asset-backed securities, where two very different stories have played out. Credit performance within sub-prime auto and marketplace lending securitizations has deteriorated, which reflects rising costs for rent, food and gas that have taken a toll on consumers at the lower end of the income spectrum. Meanwhile, mortgage credit and prime auto performance has remained robust, buoyed by rising home prices and resilient equity markets that have benefited higher earners. Tougher banking regulations may give rise to new ABS opportunities in the form of asset sales or regulatory capital transactions related to significant risk transfer.
In real estate, strong housing fundamentals underpin investments in mortgage credit. Home prices have stabilized after initially feeling pressure from rising mortgage rates. While higher prices and rates will likely hurt affordability and dampen demand, the residential housing market remains tight amid below-average supply. Home prices are thus poised to stay range bound. Against a backdrop of moderate changes in home prices and strong underwriting practices over the past decade, investors will find a positive outlook for mortgage credit instruments.
With a holistic view of the securitized credit market, patient investors with a long-term perspective will be able to seize opportunities as they reveal themselves.
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1. Mortgage Bankers Association, as of Q2 2023
The opinions expressed within are those of the authors as of January 2024 and not necessarily of PGIM. The investments and returns discussed within do not represent any PGIM product. This material makes no implied or express recommendations concerning how a client's account should be managed. This material is not intended to be used as a general guide to investing or as a source of any specific investment recommendations. In providing this material, PGIM is not acting as your fiduciary. The comments, opinions and estimates contained herein are based on and/or derived from publicly available information from sources that PGIM believes to be reliable. We do not guarantee the accuracy of such sources of information and have no obligation to provide updates or changes to these materials. The underlying assumptions and our opinions are subject to change. Distribution of this information to any person other than the person to whom it was originally delivered is unauthorized, and any reproduction of these materials, in whole or in part, or the divulgence of any of the contents hereof, without prior consent of PGIM is prohibited.
