Lehman Brothers' inclusion of commercial mortgage-backed securities in its aggregate bond index starting this Thursday is the latest, and some sources say the most significant, in a number of changes that are revolutionizing the CMBS market.
With the addition of CMBS to the index, many index funds and pension funds will have the incentive to purchase commercial mortgage securities for the first time. In addition, a buy side that has heretofore lived on a scarce diet of data now finds itself contending with a surfeit of new CMBS indexes and information from Wall Street firms. Further, such shops as Lehman and Goldman, Sachs & Co., among others, stand to benefit from the higher profile that the market is attaining by offering options like swap programs and model portfolios to newcomers who want the returns of CMBS without managing the risk.
Things began to change little more than six months ago when both Lehman and Banc of America Securities rolled out CMBS indexes designed to give investors a method of benchmarking securities. Now Merrill Lynch & Co. may also begin offering expanded information on CMBS deals, sources said.
But Lehman's inclusion of CMBS in its major bond aggregate index, one of the most widely used indexes in the fixed-income market, dwarfs all of those actions, several investors said. Having CMBS making up a portion of a leading bond index gives the business credibility and continuity, one buy-side head said. "It's hard to say that one is better than the other, but the Lehman aggregate is the single most followed from an index management standpoint," he said.
"I think it's a good move for the commercial mortgage market, as [the addition to the Lehman index] really cements it as a permanent sector within fixed income," added Michael Hoeh, senior portfolio manager at Dreyfus Corp. "CMBS is no longer going to be an off-the-run product."
The CMBS presence in Lehman's aggregate bond index will be selective, including only the ERISA-eligible top-rated CMBS, or about $65 billion in securities. While the bonds represent about 1.2% of the total index at present, buy-side sources said they believe issuance growth and longer bond maturities will cause CMBS to become a much greater component of the index, perhaps gaining territory now occupied by such sectors as corporate bonds.
Steve Berkley, a Lehman managing director who runs its index operations, said that the CMBS portion of the index would likely expand in the next few years, adding that if the potential for steady growth had not been there in the asset class, Lehman would not have included it in the first place.
With the infusion of CMBS into the Lehman aggregate index, the market could experience a variety of changes. Deal sizes may rise in order to meet the requirements demanded by the index, price tiering may occur, and spreads may tighten, sources said.
As CMBS become a greater fixture of the bond index, investors expect competition to increase, predicting at least a 10-basis-point tightening in spreads when the new index begins, and possibly more to come in the future. One speculation shared by several investors is that Lehman index-eligible bonds will eventually be priced distinctly from bonds that don't make the cut due to either size or collateral, thus creating a level of price tiering where there is little or none at present.
"Maybe this will create more of a premium for larger transactions," Hoeh said.
Rags to Riches
The CMBS market has always run on a different fuel than its mortgage-backed and asset-backed siblings. Deals require much more work to assemble and come at erratic paces. Its early deal history is sketchy, prompting Lehman to use a late-1996 cutoff point for assembling back history for its index. And its top players are not officially crowned, as Thomson Financial Securities Data does not run separate commercial mortgage-backed securities underwriter rankings, instead incorporating such deals into its general MBS rankings.
The relative lack of information on deals and pricing proved amenable to the mid-1990s, when the market was in the $15 billion to $20 billion range. But with last year's issuance total of roughly $57 billion, combined with the increased exposure the market was receiving, the old ways of pricing and grading deals had become obsolete.
It was a fertile climate for new indexes. Morgan Stanley Dean Witter had offered a CMBS index for two years, but buy-side sources said it was not widely used for comparative purposes. When then-NationsBanc Montgomery Securities and Lehman Brothers debuted their indexes early this year, the market finally had something resembling the variety of benchmarks used by other fixed-income players.
Lehman's index differs from Banc of America in its size requirements. The Lehman CMBS index requires that a deal price at a minimum of $500 million and currently have a minimum remaining balance of $300 million, while Banc of America opens its index to all varieties of deals. Banc of America's head of mortgage research, Michael Youngblood, argues that its broader policy paints a more accurate picture of the breadth and current state of the CMBS market.
But Berkley said the size and other restrictions (floating-rate and agency securities also do not make the cut) are designed to weed out smaller, illiquid deals that investors would have a hard time buying in the first place. "If you had everything in there, you'd end up with a lot of noise in the index," Berkley said. "We want to make sure the index is investible."
Stricter guidelines are becoming more common throughout Lehman's index family, with recent changes to the bond aggregate index raising the minimum size for deals to $150 million from $100 million. While Lehman argues that this is designed to better reflect current market conditions and better match investor goals, some market observers note that the changes may benefit sectors that favor large deals, such as telecom, over those that have smaller-sized offerings, like power and utility providers. - Christopher O'Leary