Analyzing Relative Value of BBB Bonds

Do Bond Investors Know Better Than the Credit Rating Agencies? 🫧 Yes according to a paper by Miles Livingston, Yao Zheng, and Lei Zhou. On November 16, 2001, Gap Inc. issued an 8.8% senior bond due December 15, 2008 with a par value of $500 million. The bond was rated BBB+ by Standard & Poor’s (S&P) and Baa2 by Moody’s, and priced to offer a yield of 8.84%. On the issuing date, the effective yield of the ICE BoA ML US Corporate BBB Index was 7.08%, and the offering yield of the Gap bond was 176 basis points higher than the average yields of similarly rated US corporate bonds. On the same date, the effective yield of the ICE BoA ML US Corporate BB Index was 8.91%.2 It therefore seems that investors priced the Gap bond more like a BB bond than a BBB one. Did investors overestimate the bond’s credit risk or were the ratings on the bond biased higher? Interestingly, within 3 months of the initial issuance, S&P and Moody’s had the bond downgraded to BB+ and Ba2, respectively — a 3-notch downgrade. This study examines the ability of bond investors to detect and adjust for potentially biased credit ratings. It finds evidence that investors require higher yield spreads on bonds with upwardly biased ratings, and that unusual yield spreads have predictive power for rating changes and defaults within 3 years of bond issuance. Bonds with unusually high yield spreads are more (less) likely to be downgraded (upgraded). Furthermore, 3-year default rates for those bonds are 2.5 times those of bonds with unusually low yield spreads. These findings suggest that yield spread could be a better measure of credit risk than ratings.

N-of-1, Value Galore! The CMBS market is vast, mature, and loaded with value: $1T market for CMBS is rallying, yet still cheap compared with historical measures, spreads, and other markets (IG/HY comparisons). Marathon Asset Management continues to extract tremendous value from the CMBS market, up-and-down the capital stack. Since every securitization is different (type such as Conduit, SASB or property type such as multi-family vs. industrial/logistics) it is hard to generalize where value is. Having said that, I will focus today’s commentary on the BBB rated sector within the CMBS marketplace since Marathon continues to extract mid-teen IRRs from BBB’s: - BBB’s which are IG-rated securities should be considered relatively ‘safe’ from a credit perspective. - BBB’s are typically structured with 8% subordination (on average); investors can get whipped around if loan defaults/losses flow thru to reduce this level of protection. - With 8% in-place subordination to protects principal, BBB-rated class have a 69%-attachment point (average), given the equity that supports the loans. - There are 1,322 distinct securitizations within the CMBS market which equates to 8,503 individual tranches. - The 1,322 CMBS securitization are backed by 68,000 commercial real estate loans. - BBB CMBS ratings (BBB+, BBB, BBB-) represent roughly 5% of the cap stack for a given securitization which equates to $50B of BBB-rated securities within the $1T CMBS market. - Note: Marathon has all 1,322 CMBS deals reverse engineered with information on all 68,000 CRE loans that back the 1,322 transactions. - To analyze a CRE loan, one must have the ability to analyze the property types, in-place cash flows, property owners/asset managers, and more with a comprehensive database and robust analytics. Takeaway 1: the CMBS market has proven to be one of the most inefficiently priced sectors within the public credit market with significant alpha to extract from credit selection and active management. Takeaway 2: CMBS remains cheap, especially the BBB sector (see graph below) in comparison to IG corporate bonds are trading at their tightest spread level since the 1990’s and/or HY bonds, which are approaching its tightest level on record too. Takeaway 3: The CMBS market is built for specialists; each deal is an N-of-1 situation. Q: Are you investing in CMBS? How closely do you study, evaluate the CMBS market?

Provocative Thinking This week I open with a quote from one of my most insightful ex-colleagues, Torsten Slok who is now Chief Economist at Apollo. In discussing the US interest rate market he notes: ”Since the Fed started raising rates, the terminal rate has fluctuated between 2% and 4.5%. That’s a pretty wide range of outcomes. The bottom line is that the market narrative at any point in time is almost always wrong.” “The Market” is a pretty broad set. It includes almost all of us because it is informed by the micro actions of each economic participant as well as the macro predictive inputs from desk jockeys like me. I have existed in markets for 40 years precisely because the market is almost always wrong. Here in Australia robust employment data seems to be closely aligned to the continuation of the immigration pulse and is delaying the inevitable rate cut. The market in the last month nevertheless has decided that the RBA will be dropping interest by 1% by this time next year. A fair call as it has to predict something. This time last year 10 year rates were within 10 basis points of today’s but in May 2024 the collective wisdom had bond rates 0.50% higher than now. Torston seems to be describing our curve! There are many other places the market is operating with short term blinkers on. In the securitised space, BBB rated paper is being issued at a credit spread of 1.35x of some AAA rated tranches in the same deal. According to rating agency expectations the BBBs can expect to default 9 times more often than AAAs. The market has got something dreadfully wrong. As with many things, it comes down to mandate. Some money managers are paid to play the yield curve so the 50 basis point swings in 10 year rates are needed for them to have a chance of outperforming their benchmark. As only about half of them manage that after their razor thin fees it seems that is a very difficult task and why so much money is now in passive index. Some credit managers are desperate for any asset that meets their mandate and are less than fussy on the pricing. Of course when there are fewer pro managers making value and credit based allocations, being in debt capital markets syndication must be the easiest financial markets job in the world. You know you are going to sell the bonds you bring to the market, the only question is whether the firm you have decided to join rubs the issuer up the right way. So it is in the ABS and RMBS space at the moment where mandate has made the BBB buyers abundant and left enormous value on the table in the oddly less popular AAA tranches. That is a tough environment for an investor who is looking for well priced lower investment grade opportunities. At the end of the day, if your core investment thesis is return on risk there are times when sitting on your hands in the short term is the only way to make your medium term goals achievable. As Torston says, “the market narrative at any point in time is almost always wrong.”