Looser Standards Threaten Lower-Ranking Commercial-Mortgage Debt

Investors adding the riskiest portions of newly issued commercial-mortgage bonds should be cautious as underwriting standards slip, according to Bank of America Corp.

Wall Street banks and rating companies are competing to win business in the $550 billion market for bonds tied to shopping malls, office buildings and hotels as sales rise, leading to looser loan terms for borrowers, Bank of America Merrill Lynch analysts said in an Oct. 21 report.

“Greater competition among originators and rating agencies increases the risks associated with owning these securities,” according to the New York-based analysts led by Alan Todd.

Hedge funds, which typically buy bonds to flip them, dominate the market for the most junior-ranked slices of new commercial-mortgage backed securities offerings, according to Bank of America. The lack of interest from so-called real-money investors, or those that invest for the long-term, makes the debt prone to price swings, the analysts said.

Some money managers that previously focused on commercial- mortgage securities rated AAA have started to buy debt with ratings as low as BBB+ to boost returns with the Federal Reserve holding its benchmark lending rate at zero to 0.25 percent for a fourth year, according to Bank of America. Hedge funds are the primary buyers for bonds rated BBB-, the lowest investment-grade ranking, the analysts said.

Relative yields on debt rated BBB- have narrowed by 50 basis points during the past month to 450 basis points more than the benchmark swap rate, the lowest this year, according to Bank of America. A basis point is 0.01 percentage point.

Wall Street has arranged about $29 billion in commercial- mortgage bonds in 2012, data compiled by Bloomberg show. As much as $45 billion may be sold this year, from $28 billion in 2011, according to Credit Suisse Group AG. Sales are down from a record $232 billion in 2007.

To contact the reporter on this story: Sarah Mulholland in New York at smulholland3@bloomberg.net

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net