In Brief
- CMBS offer attractive valuations, but we are closely monitoring credit risk dispersion between property and deal types.
- We have a positive outlook for residential MBS as we anticipate a decline in rate volatility and better supply/demand dynamics in 2024.
- We are focused on high-quality, more liquid CMBS outside of office and retail properties and favor specified MBS pools with lower coupons, attractive spreads, and higher carry.
CMBS Market Recap
CMBS Outlook
The CMBS market is already pricing in a stressed scenario, so there are clearly pockets of opportunity, but our overall outlook is balanced, as some sectors likely have more stress to come. We remain cautious on the retail sector, which is still dealing with looming issues of the past decade, and we see the potential for defaults to continue to increase in the new year. We are more positive on the hospitality sector, which has generally performed well through much of 2023. However, a slowdown in growth would certainly impact hotels, and we are avoiding those heavily reliant on business travel and conventions.
Pressures in the office segment may broadly continue for some time as companies reassess future workplace needs. However, there is a bifurcation in the sector. We believe strong demand will continue for high-quality properties in major cities, while there may be severe headwinds for older locations in need of updates or with leases expiring in the short term. Residential real estate continues to show resilience, given constrained supply of new housing and increased costs of ownership. However, we do expect increasing supply and higher rates to weigh on fundamentals and pricing. We believe there is compelling value in higher-quality, higher-rated multifamily deals with strong occupancy rates. We are also optimistic about the industrial sector in the near term. While construction on new properties has increased significantly over the last year, it has only recently caught up with demand. Going forward, we are focusing on high-quality industrial deals that may be more insulated from a slowing of the economy.
Overall, we find compelling value in CMBS, but remain cautious due to the many headwinds. Valuations are pricing in considerable economic or revenue stress and consequently offer significantly higher spreads than other areas of the bond market. While stress is likely to increase on more vulnerable properties, we will continue to focus on high-quality, liquid deals outside of the office and retail segments.
Residential MBS Market Recap
MBS Outlook
Going into the new year, we have a positive outlook for MBS with an expected decline in rate volatility and an improvement in the supply/demand dynamic. With yields above long-term averages, we expect significant inflows to bond funds generally, and particularly for MBS, given the attractive relative value. Finally, we believe the higher level of rates will continue to constrain new issuance.
In terms of positioning, we are constructive on Ginnie Mae securities over more conventional options, such as Fannie Mae and Freddie Mac MBS, given their attractive carry and less negative convexity. We are also positive on specified pools, particularly those with lower coupons, which offer attractive spreads and greater carry over to-be-announced (TBA) securities. More broadly, we continue to favor higher-coupon MBS but have started moving down in coupon somewhat, partially due to the higher prepayment speeds in very high coupon structures after the recent rally. As we enter the new year, we believe MBS will continue to be an important allocation within high-quality portfolios, given their attractive liquidity profile and diversification benefits.
About the Author
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Glossary & Index Definitions
The U.S. Federal Reserve (Fed) is the central bank of the United States. The federal funds (fed funds) rate is the target interest rate set by the Fed at which commercial banks borrow and lend their excess reserves to each other overnight.
Commercial mortgage-backed security (CMBS) is a type of mortgage-backed security backed by commercial and multifamily mortgages rather than residential real estate.
Mortgage-backed security (MBS) is a type of asset-backed security which is secured by a mortgage or collection of mortgages. The mortgages are aggregated and sold to a group of individuals that securitizes, or packages, the loans together into a security that investors can buy.
A basis point is one one-hundredth of a percentage point.
Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point). The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Typically, an analyst uses the Treasury securities yield for the risk-free rate.
Yield is the income returned on an investment, such as the interest received from holding a security. The yield is usually expressed as an annual percentage rate based on the investment's cost, current market value, or face value. Yield-to-worst refers to the lesser of a bond’s (a) yield-to-maturity or (b) the lowest yield-to-call calculated on each scheduled call date.
Bloomberg Index Information
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