April 22, 2016 / 2:20 PM / 2 years ago

Investors turn to CMBS derivatives for liquidity

* Volatility cuts new cash bond supply

By Joy Wiltermuth

NEW YORK, April 22 (IFR) - Asset managers are increasingly buying derivatives to get exposure to the commercial mortgage bond market as cash bond supply has plunged in recent months due to market volatility.

Outstanding gross notional of derivative CMBX contracts have grown by US$40bn from a year ago to US$181bn as of April 15, according to data from the Depository Trust & Clearing Corporation.

Volumes have jumped as dealers hedged their exposure to a rough market, and money managers selectively bought synthetic indices as a substitute to cash bonds.

Synthetic indices, in theory, offer investors a seamless way to trade notes that reference a basket of existing CMBS, but without the headache of finding cash bonds, at an agreeable price, through a dealer.

The most recent CMBX 9 series, for example, offers investors exposure to 25 different CMBS sold by banks in 2015.

Cash bonds, however, are tied only to the loans securitized by banks in a single deal.

With investors increasingly wary of buying cash bonds exposed to aggressively underwritten loans, a synthetic exposure to a wider group of CMBS has come into vogue as an investment alternative in volatile markets.

“Bonds available in the cash market may not be the bonds you like,” said Michael Canter, head of securitized assets at Alliance Bernstein.

“You can take on CMBX quite easily until you find the CMBS you prefer.”

Colin McBurnette, a portfolio manager at Angel Oak Capital Advisors, said increased buying of CMBX was also because real money investors were “tired of varying liquidity and idiosyncratic risks in CMBS.”

SLASHED BOND STASHES

Liquidity in CMBS bonds has fallen drastically as volatility, cuts to staff at trading desks and tough new capital rules curbed the ability of large banks to trade.

Primary dealer inventory of CMBS has shrunk to US$6.5bn as of April 6 from US$10bn in mid-April 2015, according to data from the Federal Reserve Bank of New York.

And while a three-year bull-market run created nearly US$300bn of fresh CMBS supply, deal flow recently has melted away and there is little hope that this situation will improve.

Deutsche Bank data shows that new conduit issuance has fallen 27% year-to-date versus 2015 to US$12.1bn.

Jittery markets also have made it difficult for lenders to quote new commercial real estate loans when cash bonds have dramatically sold off.

Spreads doubled on new 10-year Triple A rated securities in February to a 12-month high of 166bp over swaps from a low of 83bp in May, according to Wells Fargo data.

In early March, Triple B minus bonds jumped to a dramatic 825bp over swaps, only to bounce back, to about 600bp, on other CMBS paper a few weeks later.

“It just points to the liquidity problem in CMBS, which is not getting better anytime soon,” said one CMBS specialist.

NOT WITHOUT RISK

Some asset managers, however, are cautious about using CMBX.

David Fishman, a portfolio manager at Amherst Capital Management, said his firm includes it in a limited subset of accounts that do not bar derivatives, noting the problems plaguing the cash market also affect synthetics.

“More desks are being shut down, which means less activity in cash (CMBS) and less of a need on the CMBX side too,” he said.

“And while non-dealers may be increasing participation, the indices are still skewed to the dealers, which makes them pretty whippy.”

Other large money managers like TCW, Loomis Sayles and Invesco told IFR that they currently are not using CMBX. (Reporting by Joy Wiltermuth; editing by Shankar Ramakrishnan and Alex Chambers)

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