Risk Rules Seen Adding Fuel to Price Tiering
Price tiering on conduit bonds, which has already increased in recent months, is likely to become even more prevalent next year as the full impact of risk-retention rules is felt.
Test runs of deals complying with the new regulations have already resulted in a divergence of pricing, because investors have been willing to pay more when the issuers retain exposure to their deals. The spread over swaps on benchmark bonds has been 5-15 bp tighter than on comparable paper from noncompliant offerings.
That gives a clear indication that in secondary-market trading going forward, paper from risk-retention deals will continue to trade at a premium to the prices fetched by bonds from transactions floated without risk retention — assuming all other factors are equal.
An additional wrinkle will come if issuers, as expected, start employing different options for risk retention, which formally takes effect on Christmas Eve. In the test-run deals so far, issuers have all used the “vertical-strip” option, under which they retained 5% of each class. But there are two other choices. Under the “horizontal-strip” option, an issuer can either retain the junior 5% portion of a transaction or pass on that responsibility to a B-piece buyer. The third option is to create an “L-shape” strip that combines the two other choices. For a conduit transaction, the risk must effectively be retained for the life of the deal under any scenario.
The three options can create different risk profiles in the eyes of investors, so it’s conceivable that each will trade at a different price. Therefore, when also factoring in “legacy” deals that aren’t compliant with risk retention, there could be four different price tiers in secondary-market trading, before taking into account deal-specific factors.
Investors and traders said that given all the possible permutations, it could take some time for pricing levels to shake out. One thing that does seem clear is that investors like the concept of risk retention, which is based on the premise that lenders will write better-quality loans if they have to retain exposure to them.
“You can argue that the credit quality of the collateral in these risk-retention deals is better, so the price is better,” one trader said. But how much better is still an open question. Some investors contend that the improvement hasn’t been big enough to justify the extent of the price hike. “It feels like these vertical deals we’ve seen so far have gotten too much credit, from a spread perspective,” said one bond buyer.
The potential degree of price tiering among the three retention options is also the subject of debate. Some expect little or even no difference, while others see the possibility of a range of 10 bp or more.
Those that foresee a larger degree of tiering are divided on which retention option would be viewed most favorably by investors. Some pros predict that deals using the vertical-strip option would command the highest prices, because investors would be buoyed by the fact that the issuers themselves would retain exposure for the long haul, rather than passing it off to B-piece buyers. On the other hand, some investors favor the horizontal-strip option because a B-piece investor would effectively commit to retaining the riskiest portion of a transaction for 10 years. “It seems to me that holding the vertical strip is less risky than holding a horizontal piece,” said one CMBS portfolio manager.