Inflation and interest rates may be trending downward again, but they are likely to move at a slow pace. Meanwhile, collateralized loan obligations (CLOs) that securitize commercial loans--and other floating-rate bonds that transfer credit risk—are grabbing the spotlight and could even help regional banks manage exposures to commercial real estate (CRE).
The slight drop in inflation registered May 15 after three months of increases may indicate inflation is resuming its downward path. It also increased confidence that the Federal Reserve will cut interest rates later this year, according to Tracy Chen, portfolio manager at Brandywine Global.
"But that doesn't actually sway my thinking about rates staying high for longer," Chen said.
She added that while some data indicates the economy is slowing, the Fed will need more data to support inflation heading toward its 2% annual target. Other inflationary hurdles exist too, including the shakeup of global supply chains, a lack of fiscal discipline, the transition to renewable energy sources, and national security trumping economics, she said.
"We think that [getting inflation to retreat further] will be a slow process," she said.
Yield and CRT stories
Meanwhile, floating-rate debt is especially attractive. Chen pointed to stellar performance of commercial mortgage-backed securities (CMBS) year-to-date, especially the BBB tranche, as the market has anticipated rate cuts. Some market participants view CRE valuations as close to the bottom and others seeing more ugliness to come, she said, but private equity firms have significant dry powder to capture good deals.
"On aggregate, I'm not negative on CRE and CMBS," she said. "If investors can raise money, the market offers a lot of opportunity."
Sales in the problematic office CRE sector remain insufficient to validate valuations of most properties and loan modifications are still the primary solution, Chen said. Nevertheless, the new-issue CMBS market has opened, and reception has been strong, she said, with some BBB tranches oversubscribing.
The strong economy and the anticipation of rate cuts are factors, Chen said, and there have been significant underwriting changes strengthening today's CMBS. Office loans now make up just 15% to 25% of conduit deals, and their loan-to-value (LTV) ratios of 55% or lower and five-year durations compare, respectively, to 65% and 10 years before the pandemic.
"The new issue CMBS market is a different animal," she said.
Although spreads have compressed this year, yields remain attractive. The same holds true for CLO BBB tranches fetching yields of 7% or 8%, and CRTs yielding between 9% to 11%, Chen said, compared to the 8% or 9% provided by high-yield bonds rated B and BB. Recently low net issuance of CMBS and CLOs, which heartily withstood the housing crisis and pandemic, are pushing up prices for both those bonds, she said.
Floating-rate credit risk transfers (CRTs) floaters from Freddie Mac and Fannie Mae are especially attractive today because they have recently ceased issuing certain deal tranches, triggering a drought in non-investment-grade CRT issuance. Combined with steady credit-rating upgrades, Chen said, that has increased demand for the bonds and pushed their prices higher. In addition, those bonds typically provide a tender feature that the agencies have employed as an exit. They have offered prices typically 1% to 3% higher than market prices, she said.
CRTs enable financial institutions to transfer loan credit risk to institutional investors while retaining the assets on their books. Chen said credit-linked notes (CLNs), another type of CRT, are floating-rate investments that provide attractive yields and give institutional investors access to bank-originated assets. Several large banks, most recently Truist Bank and Ally Bank, have received Fed approvals to issue CLNs directly, rather than through a trust. Those offerings, referencing auto loans originated by the banks, are expected later this year.
Smaller U.S. regionals are also anticipated to make use of CRTs to free up capital by referencing commercial and potentially also CRE loans, like the types of deals that European banks regularly do. Chen noted that bank-originated CRE loans tend to be of higher quality than those in CMBS deals because the lenders understand their borrowers better.
"I would be interested in seeing CRE CRTs," she said.
