UPDATE 2-Commercial mortgage bond spreads soar, then steady

(Changes headline, recasts lead, adds Fitch and Barclays comments, updates spreads)

By Al Yoon

NEW YORK, Nov 20 (Reuters) - Yield spread premiums on a commercial mortgage-backed securities index soared to records for a third straight day, leading deterioration in fixed-income securities on concerns that economic weakness will boost defaults.

Relentless selling on the CMBX-5 AAA derivative index of top-quality CMBS pushed spreads as much as 170 basis points higher to a record high of 885 basis points over interest-rate swap benchmarks, according to a dealer quote.

Selling began to ease as wide spreads encouraged more traders to take the bullish side of the trade, however. Spreads on the CMBX-5 AAA index at late morning trade were wider by 120 basis points.

Spreads on CMBS jumped from 1,100 to 1,200 basis points, for yields above 15 percent. The spreads are up 635 basis points in the last month, and 1,120 basis points for the year.

Selling from investors reducing assets financed on borrowed money exacerbated the spread widening, analysts said. The process of "deleveraging" has also been blamed for skyrocketing yields on other "AAA"-rated securities, including corporate bonds and the debt of housing finance companies Fannie Mae(FNM.N)(FNM.P) and Freddie Mac(FRE.N)(FRE.P), which carry an effective government guarantee.

While the outlook for properties such as office buildings, retail stores and hotels is weakening, CMBS values reflect loss scenarios that exceed current expectations, Susan Merrick, head of the CMBS group at Fitch Ratings, said in a conference call.

"Our view is, that is technical," Merrick said, speaking of the wider spreads. "It's a reaction to the general economy and it really is not representative of the fundamentals."

Spreads also "clearly" widened following the Treasury's announcement last week to abandon its plan to use a $700 billion bailout fund to buy troubled mortgage assets in a bid to unfreeze capital markets, she added.

JUMP IN DELINQUENCIES SEEN

Fitch said it expected delinquencies on loans backing CMBS would rise to 1.5 percent to 2 percent next year from 0.51 percent in October. Office and retail properties will likely contribute more to that rate, Mary MacNeill, a managing director at Fitch, said on the call.

Fitch has identified more loans of concern for lower debt- service coverage ratios and refinancing risks, but anticipates the "AAA" portions of CMBS will avoid negative outlooks, which lead to downgrades. Lower-rated bonds take losses first.

Higher financing costs implied by yields above 16 percent could exacerbate the downturn as investors demand compensation in the form of better capitalization rates, Barclays Capital said in a note. Property values would have to drop 59 percent to equalize cap rates with the higher yield, if the adjustment were to come through price versus higher rents, said Barclays, noting that was not a forecast.

Losses could rise to 27 percent of real estate loans if prices were to fall 57 percent in the next year, it said.

"The analysis is merely a hypothetical extrapolation from the present -- hopefully brief interlude -- in which hefty liquidations have boosted CMBS yields through the roof," Tim Bond, Barclays head of asset allocation, said in the note. "However, the analysis risks becoming self-fulfilling." (Editing by Jan Paschal)