Growing concerns about loan extension potential in commercial mortgage backed securities deals and how it might impact a bond's average life led to the creation of the CMBS triple-A schedule bond in 2005, but analysts are pointing out that as a scheduled bond's cash flows do not always come from normal amortization alone additional stress testing might be necessary.
A bond's average life may extend if the underlying balloon loans whose payoffs are needed to make principal payments on the bond are unable to refinance and their maturities are extended.
Schedule bonds were created by structurers to provide investors with a stable average-life bond, whose potential for average-life extension is limited. A schedule bond is generally a seven-year average-life, wide-window super-senior AAA bond whose monthly principal payments are based on a predetermined principal balance schedule. Usually, normal amortization from the underlying pool of loans is distributed to the schedule bond to reduce its certificate balance to the scheduled balance for that payment date.
But a study from RBS Greenwich Capital showed that 9.5% of loans that reach their maturity dates extend and recent vintage deals are expected to have even higher totals. In some cases, cash flows on schedule bonds come from balloon loan maturities in addition to normal amortization. This occurs when one or more of the pool's mortgage loans is set to mature during the schedule bonds principal-window period. This balloon payment is reflected in the principal payment schedule included in each deal's prospectus.
A report from RBS, penned by Managing Director Lisa Pendergast, urges investors to closely examine schedules before buying these bonds to determine if any of the schedule bond's cash flows are coming from a maturing loan payoff.
There are currently about $100 million in schedule bonds outstanding, and this growth has led to an increasing level of liquidity in the secondary market. Pendergast suggested stressing the schedule bond by extending balloon loans to determine the potential impact on average life. While the impact is limited in most cases, market participants noted that investors are not yet compensated spread wise, often because they are not aware of some of the technical aspects of the newer bonds.
