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Time to Jump Back in the CMBS Pool?

Commercial-mortgage-backed securities are back from the dead and still have plenty of life.

The commercial-mortgage-backed securities market is alive and kicking after investors fled it in droves following the housing meltdown.

Attempts to restart the market as late as 2011 found investors at first still slow to return. But, Jeffrey Moore, a portfolio manager for Fidelity Asset Management, tells Institutional Investor that 2012 has seen a turnaround, thanks to several factors. “We’re coming out of the housing depression,” says Moore, who manages or co-manages several funds that are overweight CMBS. 

Two, FBNDX and FTBFX, are up more than 7 percent during the 12 months ending August 2. Moore cites the bottom in housing as a sign that the economy is recovering. Meanwhile, he says, smaller, so-called fused properties, where lesser properties are grouped together as part of a CMBS package and are hard or even impossible to analyze, have dropped out of higher-quality CMBS, as mortgage defaults forced the sale of buildings whose financings were part of the pools. 

At this point, Moore adds, the biggest risk other than day-to-day volatility isn’t the risk of default but rather that the owner of a building, typically in a real estate investment trust (REIT), may pay off the debt earlier than expected with a lower-interest loan. In the event of such “prepayment,” yields would fall. This is why Fidelity is selecting less-senior subordinated debt, that is, super senior CMBS tranches that are four levels below the top-rated ones, which pay holders first and therefore also suffer prepayments before lower-rated tranches do. 

“You have to pick your spot,” says Moore, who believes the A4 super senior tranche is “deep enough in the structure to protect against a negative prepayment event.” 

Fidelity’s Real Estate Income Composite Index has an average annual return of 21.1 percent during the past three years. Tracking that index, Fidelity’s Real Estate Income Fund, FRIFX, managed by Mark Snyderman, with 493 holdings, has an average annual return of 19.1 percent during the same period. For the past 12 months as of July 31, FRIFX has returned 11.4 percent. Since inception in 2004 FRIFX has averaged 7.8 percent annually. 

Snyderman has managed Fidelity real estate funds since 2003. “CMBS is a long way [up] from the bottom,” Michael Lillard, managing director and chief investment officer of Prudential Fixed Income Management, recently told journalists during the Q&A at the insurer’s 2012 Midyear Global Markets and Economic Outlook. “CMBS retained its liquidity even through the worst of the economy,” said Lillard.

There are approximately 200 publicly traded REITs in the U.S. today, which leaves lots of opportunities for entering the market, according to data gathered by the Washington, D.C.–based Real Estate Roundtable, which gathers business and trade association leaders to discuss policy, and runs education and research foundations. Although super-senior tranches also get paid first in the case of a default, holders of such tranches in residential-mortgage-backed securities got hurt anyway during the subprime crisis, simply because the entire market got whacked.

Fidelity is confident its approach to CMBS will be resistant to such problems, and not just because real estate in general is out of the woods.

Says Moore, “We know who leases the buildings, when the rent bump ups are coming. We do a lot of oversight.” Although a third of its Fidelity's holdings are in lower-rated super senior tranches that provide a bit more yield, even those tranches, says Moore, are still creditworthy enough to make the default risk more than bearable. Still, he concedes that the strategy may remain viable for only a few more years as the remaining debts in Fidelity’s tranches are amortized. 

Even so, given the recent volatility in the financial markets, most investors would be happy with any strategy that can stay in place for more than a few days.

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