One of the bond market's hottest trades from last year is losing its luster.
Commercial mortgage-backed securities returned next to nothing in the first half of the year after handing investors a whopping 11.4% in 2014 that beat everything from junk bonds to Treasuries, according to JPMorgan Chase & Co. data. They fell 1.84% in June, underperforming corporate securities and government debt, according to a Barclays index.
The bonds — which are tied to properties such as apartment complexes and shopping malls — are suffering as concern mounts that underwriting standards have slipped too much amid a boom in issuance. Borrowers are rushing to lock in cheap debt as the Federal Reserve plans its first interest rate increase in nine years, sending sales of private-label securities up 31% from 2014's pace to almost $50 billion, according to Morgan Stanley.
"The picture is unlikely to improve soon," Wells Fargo & Co. analysts led by Chris van Heerden wrote in a July 8 report.
The market is also underperforming because the notes are typically issued with 10-year terms, making them more sensitive to an increase in rates than other asset classes with shorter average maturities.Some of the most recent deals are performing the worst. Those offerings have included real estate with weaker credit outlooks and more modest price appreciation, fueling investor concern about their long-term performance. Debt underlying the securities sold last year have posted three-month delinquencies that are more than three times higher than bonds issued in 2013, according to data compiled by Bloomberg.
Bonds that were issued in 2014 and rated BBB-, the lowest investment-grade ranking, posted a 2 percent decline through June. Comparable bonds sold in 2012 posted gains of 2%, according to JPMorgan data.
Buying new, lower-rated commercial mortgage-backed bonds "is just not working today," said Marc Rosenthal, co-portfolio manager at New York-based investment firm MatlinPatterson Global Advisers.
JPMorgan analyst Meghan Kelleher forecast that commercial mortgage-backed securities will return between 0.6% and 2.1% in the second half of 2015.
Some analysts and investors say the declines have made property bonds attractive again, as yield premiums rise to as much as 4.4%, the most since the so-called taper tantrum of 2013 when investors panicked over the Fed’s announcement that it planned to raise rates.
"CMBS has outperformed until recently and that was leading some investors to find better value in other sectors, such as corporates," said Morgan Stanley analyst Richard Hill. Now that spreads have widened "the relative value proposition is now the most compelling it's been in almost a year."
The debt posted such strong performance in the past couple of years in part because property values have been climbing so quickly. Commercial real estate prices rose 13.8% in 2014 and 16.2% in 2013, according to JPMorgan data. They rose around 6.4% through the first half of this year.
Rosenthal is digging into legacy bonds to maintain higher returns as newer ones grow weaker. "It's a bond picker's market," he said, adding that some legacy bonds are outperforming by 5% to 10%.
Cerberus Capital Management's Scott Stelzer called that trade overheated in May and recommended investors bet against the debt. Too many buyers “piled into” older bonds without considering the potential of likely future losses at the end of the bonds' lives, he said.
Overall, Rosenthal sees commercial mortgage-backed securities to be under pressure for the foreseeable future as the market rears back, drawing memories of 2011 when bonds were roiled by a worsening in Europe's sovereign debt crisis and price declines eroded profits margins on new sales.
"I see it persisting through the rest of the year," he said.