10-Year AAA CMBS Spread vs. IG Corporate Bond OAS
Source: JP Data Query, Bloomberg
Chart shows 10-year new issue AAA CMBS spread to Treasuries versus the option-adjusted spread of the Bloomberg Investment Grade Corporate Bond Index.
Fixed income spreads have widened across sectors over the past few months. With a looming recession and continued inflationary concerns, our preference is to own assets that can withstand credit shocks and compensate well for the downside risks assumed. In this context, we believe structured credit is a compelling alternative to corporate credit, offering ample spread relative to the underlying risks.
- CMBS spreads, for example, are currently the cheapest they’ve ever been relative to comparable corporate bonds, presenting a rich, value-driven opportunity in the sector.
- Headwinds, such as tighter credit conditions and inflationary pressures in the form of higher property and financing expenses, do exist. As do secular challenges, such as the proliferation of work-from-home practices, that have negative valuation effects.
- But we believe current spreads at AAA levels more than compensate investors for these risks.
- AAA CMBS is a liquid, loss-remote sector that has historically traded inside IG corporates. Amid the negative narrative surrounding commercial real estate and potentially limited credit availability, however, they now offer 30 bps more in spread.
- The spread on these senior claims now rivals what lenders have been paid for making mortgage loans, which are a form of illiquid non-diversified risk with no loss protection.
- AAA CMBS also have features that we believe help to mitigate the risk of principal loss or extension:
- They have 30% credit support, a loss level that has never been breached, not even during the GFC.
- Among the most aggressively underwritten pre-GFC vintages, losses only reached 11.17%, implying a coverage ratio of 2.7x. This coverage ratio should keep these bonds safe from nearly any ratings downgrade.
- As new 10-year loans, these bonds do not need capital markets to be open in the near to medium term, shielding them from refinancing risk.
- Structured credit is an inherently fragmented and inefficient market, as this CMBS opportunity illustrates. This ability to obtain high spread with much lower risk relative to other credit assets is what we think makes structured credit a vital tool in a fixed income portfolio.
- GMO’s Opportunistic Income Strategy, which follows an unconstrained, value-driven approach to investing in structured credit, has meaningfully increased exposure to AAA CMBS in recent months.
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