The market is grossly mispricing heavily defeased CMBS, although it is true that the illiquidity and weak technicals make it difficult to trumpet relative value in the current
market, Barclays Capital analysts said in a recent report.

According to the analysts, even those investors who are now sidelined should still look at the value implications of defeased paper, while awaiting a better value-investing scenario.

Over the past few years, Barclays said that strong commercial real estate price appreciation caused many borrowers to exercise their defeasance option to prepay the loan as well as unlock equity. However, weak origination activity has hindered recent defeasance volumes.

But, analysts still acknowledged that the 2005 to 2007 surge in defeasances left many older vintage collateral pools with over 25% in risk-free collateral. Such risk-free assets should command a premium in today’s uncertain environment, they said, although current market spreads make it seem that investors only partially recognize the benefit.

The risk profile of owning senior CMBS paper supported by partially risk-free securities is like owning a portfolio of risk-free debt and a senior CMBS bond with defeasance
adjusted credit enhancement, analysts noted.

Even though markets seem to recognize the effect of higher adjusted credit enhancement  — pricing high defeasance paper roughly  five to 10 basis points  tighter depending on the vintage — analysts still think that bonds with high defeasance should command an additonal a 20 to 40 basis point premium compared with non-defeased senior tranches as a result of a more favorable risk profile.

In short, the analysis highlights two key effects of defeasance on senior CMBS note valuations. These are the higher effective credit enhancement on the portion of the bond backed by CMBS loans and a more favorable risk profile resulting from the portion of the bond backed by Treasurys.

While the effect of higher credit enhancement is widely recognized, analysts think that the other effect is not fully priced in. A partially defeased senior CMBS security can in theory be decomposed into a portfolio of two securities made up of a pro-rata share of a fully defeased bond and a senior CMBS note with adjusted credit enhancement, they explained.

The spread of such a position should be close to the value of the weighted average spread of a fully defeased bond and a credit-enhanced senior CMBS note, according to Barclays.

"This is consequential even in the current dislocated market, but should command greater focus among relative value investors if and when the market starts to recover," analysts wrote.

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