Bond buyers are devouring the most commercial-mortgage debt linked to everything from skyscrapers to Hawaiian resorts in more than five years, allaying concern that an onslaught of sales would be too much to digest.
Even as Bank of America Corp. estimates sales of the securities more than doubled to $10.7 billion this month, investors have pushed down the rate on the top-ranked portion of transactions maturing in 10 years to 0.72 percentage point above the benchmark swap rate of 2.06 percent. That difference is the narrowest since issuance revived in 2009.
Buyers are seeking commercial-mortgage bonds after property values recovered 45 percent since bottoming in December 2009 and as the Federal Reserve holds interest rates at almost zero into a fifth year. They’re defying some investors’ expectations that the rush of offerings could lead to a logjam, according to Ellington Management Group ‘s Leo Huang.
“Investors still have their buying hats on,” said Huang, an investment manager overseeing commercial real-estate debt at the Old Greenwich, Connecticut-based firm founded by Michael Vranos in 1994. “The market is holding up to the supply much better than it has in the past couple of years.”
JPMorgan Chase & Co. and Deutsche Bank are selling $2.5 billion in bonds linked to the 2010 buyout of Extended Stay Inc., the largest offering since 2007. This month’s sales are the most since November of that year, when a record $232 billion was offered, according to data compiled by Bloomberg.
Sales are rising after the market shut down when credit markets froze in 2008. Issuance is forecast to increase by more than 50 percent to as much as $70 billion in 2013, according to Credit Suisse Group.
The banks already sold about $500 million of the securities backed by so-called mezzanine debt, which gets paid after the first mortgage and offers buyers higher yields. The lenders last week sold a $245 million slice of the mezzanine portion to pay 559 basis points more than the benchmark swap rate, after marketing the securities to yield 578 basis points, according to people familiar with the offering who asked not to be identified because terms aren’t public.
“At 15 times oversubscribed, the mezzanine distribution process was redolent of a bacchanalian 2007 syndication,” said Ed Shugrue, chief executive officer of Talmage, who oversees $2 billion of commercial property debt in New York.
Elsewhere in credit markets, Warren Buffett’s Berkshire Hathaway and Netflix led at least $10 billion of corporate bond offerings in the U.S. as sales surpass last January’s total. Bank of America cut its outlook for returns on investment-grade bonds. Pharmaceutical Product Development Inc. was said to have cut the rate it will pay on a $1.46 billion covenant-lite term loan.
The U.S. two-year interest-rate swap spread, a measure of debt-market stress, decreased 0.74 basis point to 15.88 basis points. The gauge narrows when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.
The cost of protecting corporate bonds from default in the U.S. rose for a second day. The Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, increased 0.4 basis point to a mid-price of 86.3 basis points, according to prices compiled by Bloomberg.
The Markit iTraxx Europe Index of 125 companies with investment-grade ratings dropped 2.4 to 109. In the Asia-Pacific region, the Markit iTraxx Asia index of 40 investment-grade borrowers outside Japan climbed one to 110.
The indexes typically rise as investor confidence deteriorates and fall as it improves. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
Bonds of Fairfield, Connecticut-based General Electric Co. were the most active dollar-denominated corporate securities Tuesday, accounting for 3.44 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Berkshire raised $2.6 billion, selling three-, five-, 10-and 30-year debt and Los Gatos, California-based Netflix more than doubled its debt with a $500 million issue, according to data compiled by Bloomberg. Offerings of at least $150 billion this month have surpassed the $129 billion of bonds issued in January 2012.
A “disorderly rotation” into equities from bonds may lead to outflows from investment-grade funds and wider relative yields, Hans Mikkelsen, a Bank of America credit strategist in New York, wrote in a report dated Jan. 28.
“We now consider it most likely that total returns will fall short of our low 1.6 percent target,” Mikkelsen wrote. “The risk of the rotation out of bonds, into equities starting in 2013, has increased enough to become our base case.”
The loan due 2018 to Pharmaceutical Product Development, a provider of drug-discovery and development services, will now pay interest at 3.25 percentage points more than the London interbank offered rate, down from 3.5 percentage points and will be sold at par, according to a person with knowledge of the transaction. The Libor floor will remain unchanged at 1 percent.
The interest rate will drop to 3 percentage points more than Libor when leverage through the first-lien is less than 3.25 times, the person said.
In emerging markets, relative yields narrowed 2 basis points to 255 basis points, or 2.55 percentage points, according to JPMorgan Chase & Co.’s EMBI Global index. The index has fallen from 265.8 at year-end.
The recovery in commercial-mortgage bond issuance is accelerating as investors wager that economic growth will boost income for properties across the U.S. even as property values appear on the verge of plateauing, according to Moody’s Investors Service.
“With capitalization rates poised to increase and net operating income trending down, core commercial prices will give back a portion of their post-trough recovery,” Tad Philipp, an analyst at Moody’s, said in a Jan. 10 report.
Payments more than 60 days late fell 10 basis points to about 9 percent last month, according to Barclays Plc. The rate has been declining since reaching a record 9.7 percent in July of last year as borrowers struggled to refinance a wave of maturing mortgages from the boom years, Keerthi Raghavan, an analyst at Barclays said in a telephone interview. Rising sales are a boon for borrowers with loans coming, meaning the delinquency rate should keep falling, he said.
The size of new deals could get bigger as demand for debt surges. Offerings that bundled loans from multiple borrowers grew to be as large as $7.6 billion when issuance peaked in 2007, Bloomberg data show. Those types of deals currently being sold are between $1 billion and $1.5 billion.
The revival of the $550 billion commercial-mortgage bond market has been stymied as bouts of volatility stemming from the debt crisis in Europe sent investors fleeing to the safety of Treasuries.
“The appetite for deal size could definitely go up,” Tim Gallagher, a managing director in the CMBS group at Morgan Stanley, said this month at the Commercial Real Estate Finance Council’s annual convention in Miami. “Size could grow to $2 billion. The capacity is there. The issue is it’s problematic to have a $2 billion deal when the market is volatile and nobody wants to be involved.”
It takes several months to accumulate mortgages from multiple borrowers for sale as bonds and price swings in the interim can erode profit margins on new transactions.
The $2.5 billion Extended Stay transaction, the biggest since Bear Stearns Cos. issued $2.5 billion of the securities in December 2007, is different from standard CMBS deals that package as many as 100 loans from many borrowers in that it’s linked to a single portfolio of properties acquired by Blackstone Group, Centerbridge and Paulson & Co. in a 2010 bankruptcy auction.
Goldman Sachs Group Inc. started marketing a similar $1.1 billion deal Tuesday tied to six hotels owned by Cerberus Capital Management including the Sheraton Waikiki in Hawaii, a person familiar with that sale said.
“Issuers are happy as clams so they’ll likely stay with the current low-$1 billion conduit deal sizes,” said Huang of Ellington, who was co-head of commercial real estate lending at Goldman Sachs from 2004 to 2008. “2011 was challenging with 2012 being the first home-run year post-crisis for street issuers. They are not quite ready yet to take on the aggregation risk.”
The surge in new deals follows a rally in the first two weeks of January that saw values on some lower-ranking commercial-mortgage bonds rise 15 percent, according to Alan Todd, a debt analyst at Bank of America. Average CMBS returns were 9.07 percent in 2012, according to a Bank of America Merrill Lynch index.
“The amount of money that needs to be put to work continues to overwhelm the amount of supply in the market,” Todd said. “Deals are being well absorbed, despite the acknowledgement that the pipeline is fairly robust.”