07/08/2011

Bond Pros Foresee Resumption of CMBS Rally

Despite the recent plunge in bond prices, commercial MBS professionals expect a long-running rally to resume in the second half for high-grade paper from both new issues and legacy deals.

Bond pros are also optimistic that the prices of new-issue bonds rated triple-B will rise by yearend. But their outlook is bearish for triple-B paper from deals floated in 2006 and 2007.

The spread on long-term, triple-A bonds from new issues will tighten to 111 bp over swaps by yearend, from 130 bp on June 30, according to the average prediction of 16 respondents to a Commercial Mortgage Alert survey (see list of forecasts on Page 10).

If so, that would be good news for CMBS lenders, which were battered by the sudden widening of spreads last month. After a huge rally had driven down the average spread on long-term, triple-A bonds to a range of 100-105 bp from early April to early June, the level suddenly blew out to 140 bp. That forced CMBS lenders to increase loan spreads, further weakening their position relative to portfolio lenders. Some of that damage was offset by the end of last month, when the average spread backtracked to 130 bp.

Only two of the prognosticators expect spreads on senior new-issue bonds to widen during the second half. Traders David Cook of Barclays and Tim Gallagher of Morgan Stanley think the level will finish at yearend slightly higher, at 135 bp.

The biggest bull is Credit Suisse trader Chris Callahan, who believes the average will contract to 80 bp at yearend. Also bullish is Darrell Wheeler, CMBS strategist at Amherst Securities, who thinks the spread will drop to 88 bp. Both cited pent-up demand for high-grade offerings and the fact that CMBS still looks cheap compared to corporate bonds, residential MBS and asset-backed securities.

Callahan figures that, after pulling back from the market in June, insurers and other traditional buyers of CMBS will return, boosting demand for “high-quality paper with some spread left to it.”

Added Wheeler: “The real cash money hasn’t stepped up as much as it probably can, and the issuance in the second half is going to be lower than what some people expect.”

But the panel of bond pros expects a rocky ride in the near term because of limited risk tolerance on Wall Street, stemming from uncertainty about the European debt crisis, the U.S. economic outlook and political battles over federal spending. “There’s obviously a lot going on that we have to work through,” said RBS analyst Brian Lancaster. “The summer will remain volatile for CMBS values.” He thinks senior spreads will tighten to 110 bp at yearend, putting him in the middle of the pack of forecasters.

The panel also expects spreads on new-issue bonds rated triple-B to fall over the next six months. The average prediction is that the level will tighten to 352 bp, from 425 bp at the end of June. Portfolio manager John Beaman of AREA Property is the most bullish, with a forecast of 250 bp, followed closely by Malay Bansal of CapitalFusion, at 270 bp. “New-issue triple-Bs may be one of the places in CMBS with better upside potential if you can endure some volatility,” said Bansal.

But there is some sentiment that CMBS investors will demand higher yields on triple-B bonds relative to senior paper, causing spreads to widen. Trader Tom Digan of Sorin Capital projects those spreads will jump by 75 bp, to 500 bp. Two others expect a less-dramatic increase of 25 bp — sellside analyst Harris Trifon of Deutsche Bank and buyside analyst Aaron Bryson of New York fund shop Spring Hill Capital.

As for legacy paper, the outlook is mixed. The forecasters were bullish across the board about senior paper. Ten-year, super-senior bonds floated in 2006 and 2007 ended up on June 30 at 187 bp, down from 214 bp at yearend 2010, according to Trepp. The average forecast is that the spread will tighten further in the second half, to 165 bp. Individual predictions ranged from 120 bp to 185 bp.

But the bond pros are pessimistic on the outlook for legacy bonds rated triple-B at issuance. The average prediction is that the going rate on such paper will fall to 9 cents on the dollar, from 13 cents at midyear. Individual predictions ranged from 5 cents to 15 cents.

The prevailing view is that the principal balances of most triple-B bonds will be wiped out as defaults mount. So buyers of such paper are betting that the bonds will continue to pay interest long enough to produce a profit. But opportunities for such trades are drying up as deals age.

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