Don’t expect much of an impact on structured finance next year from the Fed rate hike and its decision to raise rates gradually.
This is particularly true if a more robust economy gives borrowers the extra wherewithal to easily handle small increases in the rates they pay.
CMBS: Surfing the maturity wave
We’re now approaching the crest of the CMBS maturity wave that, just a few years ago, had players on tenterhooks.
Thanks to high property values and exceedingly low interest rates, refinancing this year proved to be a breeze. That’s unlikely to change much next year.
Darrell Wheeler, head of structured finance research at Standard & Poor's, said that it remains highly unlikely that the $105-billion in CMBS tracked by S&P that matures next year will have issues refinancing loans because of interest rates. “A lot of the mortgages out there have rates of 5% or 6%,” he said. “Most of those are still refinancing into lower rates."
A key metric used in assessing real estate is cap rates—basically the return on a property. Low cap rates have recently driven up commercial real estate prices. The inverse, rising cap rates, would typically make it harder for commercial borrowers to refinance—potentially hurting, for instance, more seasoned CMBS. But this impact could be tempered, or even overridden, by rising rents in a faster growing economy.
But how will a rise in longer-term interest rates affect cap rates?
Wheeler said S&P’s research had found that the cap rate on commercial property had only limited correlation to the 10-year Treasury when its yield was below 5% or above 9%. Beyond that the cap rate is "also related to inflation expectations, the employment rate and other factors,” he added. “As a result, a dramatic move in the 10-year Treasury to over 3% in the next couple of years from 2.3% currently shouldn’t have much an impact on the cap rate.”
One factor that moves more in sync with the CRE cap rate is the spread on triple-B credit. “When people are considering real estate, they’re also considering ‘should I buy other investments alternatives such as triple-B bonds or equites?” Wheeler said. “This this credit spread factor captures the universe of alternative investments that they might be able to consider.”
RMBS: Watch the yield curve's slope
On the RMBS front, Moody’s Investors Service Managing Director Navneet Agarwal said in a brief that the slope of the yield curve is what matters.
If, in this rising interest-rate environment, the yield curve keeps its upward slope or actually steepens—that is, long-term rates go up more dramatically than short-term ones—then the credit quality of new mortgage-backed deals will deteriorate.
The catalyst of this would be a rising portion of hybrid adjustable-rate mortgages (ARMs) in the pools underlying RMBS. Borrowers will proportionally take out more ARMs with a steeper curve because this type of loan has a lower initial rate. But, by the same token, ARMs are riskier than fixed-rate loans as a borrower that could pay the initial interest might have trouble making payments once that rate resets higher.
On the flip side, a flattening of the yield curve—higher short-term rates, without long-term rates rising as much—could help the credit quality of new RMBS as borrowers lock in rates.
As far as outstanding RMBS are concerned, a “modest increase” in long-term shouldn’t have a strong impact.
“Although lower prepayments will slow the buildup of credit enhancement and extend the average lives of the bonds, excess spread, credit enhancement and fewer new defaults owing to an improving economy will offset most of the negative impact,” Agarwal said.
Consumer ABS: Prepayment speed could slow
Moody’s MD Will Black said that in most segments of consumer ABS, the gradual rise in short-term interest rates engineered by the Fed will be credit neutral.
Some borrowers with floating-rate debt may naturally see their debt load rise, but this might could happen in tandem with higher incomes and lower unemployement, both of which help the performance of consumer deals.
Another impact (which could be negative or positive): lower prepayment rates in a range of assets could slow down the prepayment speeds of outstanding securitization.
S&P’s Wheeler said many structured finance bond classes are insulated from prepayment speeds. "But there is always a class within the structure that will benefit or suffer with prepayment speed changes depending on whether it is a premium or discount bond," he added.
