Tightening Credit Spreads in a Declining Rate Environment

October 31, 2019

Tightening Credit Spreads in a Declining Rate Environment Photo

In an ongoing search for yield, the commercial mortgage-backed securities (CMBS) credit curve continues to flatten this year, led by tighter spreads for BBB-rated investments. Over the course of 2019, risk premiums across most fixed income markets have grinded tighter. The CMBS market continues to experience spread tightening across the capital stack. This week’s chart highlights the spread compression of 10-year AAA CMBS bonds relative to BBB-rated bonds (Credit Curve) and a corresponding decline in yields.

A tightening credit curve reflects a vote of confidence from investors who do not perceive any significant credit concerns on the horizon. The spread for safer, higher-rated AAA bonds has traded in a narrow range this year, while lower-rated bonds continue to tighten. The current spread between a AAA-rated bond and a BBB-rated bond is 181 basis points (bps), compared to 314 bps at the beginning of the year. Investors have been willing to accept reduced spreads for CMBS credit bonds as overall commercial real estate fundamentals remain healthy.

What has been somewhat surprising is the corresponding decline in Treasury rates and overall yields that investors are now earning compared to the start of the year. The market was not forecasting three rate cuts by the Federal Reserve this year. Ten-year Treasury yields are currently around 1.80%, a level last seen in 2016. This represents a spread tightening of 88 bps year-to-date. The all-in yield for a AAA-rated bond has fallen 121 bps in 2019 compared to 254 bps for BBB-rated bonds. Declining interest rates have created a more challenging environment for yield-based investors.

Spreads across the risk spectrum in CMBS remain near 12-month lows. Tightening spreads have been supported by favorable demand, healthy fundamentals and investors with cash to deploy. As we head into the later innings of this economic cycle, I remain cautious given forecasted decelerating growth and a flattening credit curve. The incremental yield pickup for lower-rated securities is narrowing. I believe higher-rated investments are less volatile and will outperform in a spread-widening event.

Key Takeaway

Overall, with a flatter credit curve, I remain up in quality and shorter in duration as gains in the commercial real estate market are likely to decelerate. While historical losses in the CMBS market have been relatively low, I do not believe investors are being compensated to take on incremental risk. As we move into the later stages of the current real estate cycle, I remain cautious about going down in credit given the current risk-reward opportunity.

Tags: CMBS | Commercial mortgage-backed securities | commercial real estate | Interest Rates

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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.  This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

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