In the face of a crippled corporate bond market, investors have had to increasingly keep their eyes on alternative investments, and if recent default data is any indication, commercial mortgage-backed securities might be the relative value they are looking for.

A Fitch study released last week showing relatively low default rates for CMBS compared to corporates over the 10-year period from 1990 to 1999 only serves to bolster analysts' assertions that CMBS credits are as good or better than similarly rated corporate credits.

For the study, entitled "Comparing CMBS and Corporate Bond Defaults," Fitch analysts personally surveyed more than 540 domestically rated CMBS transactions - approximately $230 billion worth of paper - excluding international, credit lease-backed and unrated deals. Similarly, they compared their findings to corporate-bond information which was culled from several different sources.

And the results were very interesting, if not a bit surprising: CMBS outperformed high-yield corporates across the board - despite the fact that a majority of corporate defaults are in real-estate-related sectors.

"CMBS is a relatively new industry, and you'd expect minimal defaults because the economy has been so good," said Diane Lans, a co-author of the Fitch study. "But the results are somewhat surprising, because in the corporate market, some of the highest default rates were in sectors affecting commercial real estate, so you would think there's a high correlation there. But it hasn't trickled down into the CMBS market."

In fact, CMBS bonds also showed strong performance compared with narrower industry sectors. The average annual default rate on non-investment-grade-rated corporate bonds between 1990 and 1999 was 3.07%, which is significantly higher than the non-investment-grade CMBS average annual default rate of 0.14% for the same period.

Lans attributes the comparative success of CMBS to diversification in CMBS transactions, which serves to insulate the sector from the high rate of corporate-bond defaults in commercial real estate-related sectors, such as retail, supermarkets, drugstores, gaming, lodging and restaurants.

"The bankruptcies in retail sectors have caused problems at the loan level," Lans said. "However, given the number of loans in transactions and the diversification of property types, it has not resulted in defaults of CMBS bonds to date."

A Safe Harbor

The Fitch study supports the contention of market analysts who not only concur with it but feel that CMBS has become a safe harbor for investors recently because the sector is, in fact, overcollateralized.

"When the agencies developed their models they had the last recession in mind, and may have overcompensated for a potential reoccurrence," said Darrell Wheeler, a CMBS strategist at Salomon Smith Barney. "Recently corporate bonds have experienced a tough market, as investors consider a possible economic slowdown and the fact that recent defaults have been random and unpredictable. In contrast the CMBS market has the benefit of being structured, so if there is a delinquency it is usually a small portion of the underlying transaction presenting little possible credit impact. This structured nature of CMBS has enabled their spreads to tighten to corporates."

According to Wheeler, even with a 6% decline in CMBS subordination levels, CMBS pools can still withstand a high frequency of defaults and loss severity prior to experiencing a loss. "The credit support built into 2000 CMBS transactions is well in excess of that found in high-risk mortgage security products (subprime or home-equity loans)."

A mortgage pool experiencing a 40% loan loss would require 39% of the loans to default before the single-A rated class lost any of its principal. "If we accept that a 40% expected loss is reasonable, then the projected default rates for triple-A through triple-B seem very conservative relative to historical default data and projections for the next real estate recession," Wheeler said.

Moreover, CMBS may be a better option than corporates because of structural reasons. According to Wheeler, many CMBS downgrades usually only downgrade a certificate one notch, from A to A-minus, because of the subordinate credit enhancement built into the transaction. Corporate downgrades, on the other hand, have demonstrated that they can move through multiple classes.

"In addition, the CMBS market continues to demonstrate strong liquidity that should weather any economic stress as long as the underlying collateral fundamentals remain strong," Wheeler noted. "But if the economy continues to slow and corporate tenants weaken, eventually the corporate tenants' performance can have an impact on the underlying commercial properties."

However, Wheeler and others feel that the attractive subordination levels and protection offered by CMBS will push spreads in even further next year.

"We expect 2000 issuance will become another vintage subordination level year and quickly season to tighter spreads," Wheeler said.

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