Deutsche Bank AG and Nomura Holdings Inc. are urging caution as investors gorge on junk-rated commercial-mortgage bonds, wagering that economic growth in the U.S. will curb losses.
Prices on so-called AJ bonds have climbed as much as 25 percent since December, according to Deutsche Bank. The bonds, which were rated AAA when they were issued during the years leading up to the property market crash in 2007, were downgraded as delinquencies on boom-era commercial mortgage soared past 13 percent, according to Wells Fargo & Co.
Even as property values surpass peaks reached in 2007, investors may be ignoring the risk that losses incurred by the default on a single property can dictate the fate of the bonds, according to Nomura analysts.
“This portion of the capital stack continues to carry both interest and principal loss risk,” Nomura analysts Lea Overby and Steven Romasko said in a report yesterday. As delinquent loans are resolved, “losses will begin to erode the face amount of these tranches in a significant portion of the CMBS universe.”
A security sold by Morgan Stanley in December 2006, currently rated CCC by Fitch Ratings and B+ by Standard & Poor’s, climbed to about 94 cents on the dollar this month, from 75 cents in December, Deutsche Bank data show. Similar debt issued by Merrill Lynch in May 2007, now rated CCC by S&P and Caa3 by Moody’s Investors Service, has jumped to 45 cents from 35 cents in December, according to the data.
“If these bonds perform the way they are supposed to, then there is probably more room to tighten,” said Andrew Solomon, a managing director at New York-based investment firm Angelo Gordon & Co. “But there are going to be individual deals that aren’t going to perform the way people are expecting, and at these kinds of prices, that’s going to generate some pretty significant negative returns.”
Commercial-mortgage backed securities prices are climbing as values for high-quality properties surge past 2007 levels amid low interest rates and “modest economic growth,” according to Green Street Advisors.
Gains in CMBS have outpaced those of most other fixed-income assets as investors pursue riskier debt amid a fifth year of near-zero interest rates and against the backdrop of an improving real estate market, according to Deutsche Bank. Hedge-fund managers including Saba Capital Management LP’s Boaz Weinstein and Tom Kempner of Davidson Kempner Management LLC cited CMBS as their best investment idea at the EnTrust Investment Summit in New York in February.
“Prices on the bonds have only really gone one way,” Deutsche Bank analysts led by Harris Trifon said in a report yesterday. ‘It’s an opportune time to explore whether at some point in the not-too-distant future, the buyers of the riskiest AJs will suffer a bout of buyer’s remorse.”
While none of the bonds have yet taken principal losses, a deal sold by Morgan Stanley in December 2007 is poised to be the first, according to Deutsche Bank.
The largest loan in the $1 billion transaction, backed by The Pier Shops at Caesars, a mall on Atlantic City’s boardwalk, defaulted in 2011. The building failed to attract a minimum bid during an auction in August. The property has been battered by a slump in casino traffic in the New Jersey shore town and a drop in tourism since Hurricane Sandy. Valued at $210 million in 2007, it could ultimately sell for as little as $10 million, the Deutsche Bank analysts said.
While the outlook for the best buildings in major markets is promising, low interest rates and abundant financing will not be enough to save all borrowers, said Angelo Gordon’s Solomon.
“That stuff doesn’t matter for something like the Pier at Caesars,” he said.