CMBS IO
4
CMBS IOs: Vintage versus Structure CMBS IOs are one of the more complex security types in the commercial mortgage-backed secu- rities (CMBS) market. Although many investors understand WAC (weighted average coupon) IOs, more recent types such as PAC (planned amortization class) IOs and support IOs are commonly mis- characterized. Despite the various qualities the different names may connote, the rate environment when the IO is being constructed is every bit as important as how the IO is structured. Indeed, understanding the interaction between the structure, the CMBS credit curve at issuance and the rate environment during the gestation period is key in determining relative value between different types of IOs with different vintages. This report examines these issues in detail and points out what we believe to be an excellent current relative value opportunity in the market—recent vintage support IOs. WHAT IS A CMBS IO? A CMBS interest only security (IO) is created from the interest difference between the coupons on the commercial mortgage loan collateral of a CMBS deal and the coupons on the CMBS securities. Originators typically need to strip interest off of the underlying collateral so that the coupons on the CMBS bonds are low enough in order that the bonds can be priced at or near par. The size of the IO or the amount of this interest differential will depend on the course of interest rates during the gestation period 1 as well as the shape of the CMBS credit curve. 2 The more rates fall during the gestation period, the larger will be the IO bonds since the coupons of the bonds (ceteris paribus) will be that much lower than the coupons on the underlying commercial real estate collateral. Also, the steeper the credit curve at issue (ceteris paribus) the larger the IO bonds again, as more interest will have to be stripped off the deal to bring the largest AAA bond coupons down to par. ALL IOS ARE NOT CREATED EQUAL Understanding the interaction between the structure and the rate environment during the gestation period of CMBS is key in determining relative value between different types of IOs with different vintages. When rates fall during the gestation period, the IO portion of the deal tends to be large and stripped off all the classes in the deal. The quality of the IOs created, whether WAC, PAC or support, tends to be high. Conversely, when rates rise during the gestation period, the IO strip tends to be “barbelled” and the quality low, that is, the IOs tend to be more volatile. The slope of the CMBS credit curve at the time of deal issuance also plays an important role in the quality of the IO or how barbelled the IO class is. If the credit curve is steep between the highest rated classes (their coupons are relatively lower) and the mezzanine bonds (their coupons are relatively higher), then more IO will have to be stripped off the higher rated, lower coupon bonds and less can be stripped off of the lower rated, higher coupon mezzanine bonds. This will contribute to a more barbelled, lower quality IO. For example, the 1999–2000 vintages were not particularly good for WAC IOs. CMBS IOs are created from the excess interest resulting from the difference between the coupons on the underlying collateral and the coupons on the CMBS bonds. Thus, when interest rates rise between the time of commercial mortgage origination and deal issuance, as was the case in 1999–2000, there is little interest left to create an IO (Chart 1). Indeed, the only bonds available for stripping are typically the shorter-maturity, lower-coupon early tranches (assuming the yield curve is steeply sloped) and the lower-rated classes. The coupons of shorter-maturity tranches are stripped so the tranches may be priced at par. The lower-rated classes are stripped to typically offer only a low coupon of 100 basis points (bp) over Treasuries because their high yields are derived from their steeply discounted dollar prices. The quality of the collateral notwithstanding, these tranches are the most volatile parts of a CMBS deal. 38 CMBS WORLD ™ Brian Lancaster and Scott Fuller SM Lancaster Understanding the interaction between the structure and the rate environment during the gestation period of CMBS is key in determining relative value between different types of IOs with different vintages. “ ”
Transcript of CMBS IO
CMBS IOs:Vintage versus Structure
CMBS IOs are one of the morecomplex security types in thecommercial mortgage-backed secu-rities (CMBS) market. Althoughmany investors understand WAC(weighted average coupon) IOs,more recent types such as PAC(planned amortization class) IOsand support IOs are commonly mis-characterized. Despite the various
qualities the different names may connote, the rateenvironment when the IO is being constructed is everybit as important as how the IO is structured. Indeed,understanding the interaction between the structure, theCMBS credit curve at issuance and the rate environmentduring the gestation period is key in determining relativevalue between different types of IOs with differentvintages. This report examines these issues in detail andpoints out what we believe to be an excellent currentrelative value opportunity in the market—recent vintagesupport IOs.
WHAT IS A CMBS IO?A CMBS interest only security (IO) is created from
the interest difference between the coupons on thecommercial mortgage loan collateral of a CMBS deal andthe coupons on the CMBS securities. Originatorstypically need to strip interest off of the underlyingcollateral so that the coupons on the CMBS bonds arelow enough in order that the bonds can be priced at ornear par. The size of the IO or the amount of this interestdifferential will depend on the course of interest ratesduring the gestation period1 as well as the shape of theCMBS credit curve.2 The more rates fall during thegestation period, the larger will be the IO bonds since thecoupons of the bonds (ceteris paribus) will be that muchlower than the coupons on the underlying commercialreal estate collateral. Also, the steeper the credit curve atissue (ceteris paribus) the larger the IO bonds again, asmore interest will have to be stripped off the deal tobring the largest AAA bond coupons down to par.
ALL IOS ARE NOT CREATED EQUALUnderstanding the interaction between the structure
and the rate environment during the gestation period ofCMBS is key in determining relative value betweendifferent types of IOs with different vintages. When rates
fall during the gestation period, the IO portion of thedeal tends to be large and stripped off all the classes inthe deal. The quality of the IOs created, whether WAC,PAC or support, tends to be high. Conversely, when ratesrise during the gestation period, the IO strip tends to be“barbelled” and the quality low, that is, the IOs tend tobe more volatile.
The slope of the CMBS credit curve at the time ofdeal issuance also plays an important role in the qualityof the IO or how barbelled the IO class is. If the creditcurve is steep between the highest rated classes (theircoupons are relatively lower) and the mezzanine bonds(their coupons are relatively higher), then more IO willhave to be stripped off the higher rated, lower couponbonds and less can be stripped off of the lower rated,higher coupon mezzanine bonds. This will contribute toa more barbelled, lower quality IO.
For example, the 1999–2000 vintages were notparticularly good for WAC IOs. CMBS IOs are createdfrom the excess interest resulting from the differencebetween the coupons on the underlying collateral andthe coupons on the CMBS bonds. Thus, when interestrates rise between the time of commercial mortgageorigination and deal issuance, as was the case in1999–2000, there is little interest left to create an IO(Chart 1). Indeed, the only bonds available for strippingare typically the shorter-maturity, lower-coupon earlytranches (assuming the yield curve is steeply sloped) andthe lower-rated classes. The coupons of shorter-maturitytranches are stripped so the tranches may be priced atpar. The lower-rated classes are stripped to typically offeronly a low coupon of 100 basis points (bp) overTreasuries because their high yields are derived fromtheir steeply discounted dollar prices.
The quality of the collateral notwithstanding, thesetranches are the most volatile parts of a CMBS deal.
38 CMBS WORLD™
Brian Lancaster and Scott Fuller
SM
Lancaster
Understanding the interaction between the structureand the rate environment during the gestation period
of CMBS is key in determining relative value between different types of IOs with different vintages.
“”
WINTER 2002 39
Should a default-induced prepayment occur on thecollateral, it would first be paid to the initial AAA CMBStranche—not a good thing for an IO stripped off thosebonds. On the other hand, should a loss occur, it wouldcome off the lowest-rated tranches, again not good for theIO stripped off that tranche because less interest would
be paid out going forward. The result is a barbell-shapedIO.
This type of structure is clearly shown by the IOcomponents of FUNB 00-C1, created in April 2000(Chart 2). This IO is made up mostly of interest strippedoff the volatile front-end classes and the subordinateclasses, thus the barbell-shaped WAC IO.
Other WAC IOs created in 1999–2000, such as the IOsfrom BSCMS 00-WF1 and JPMC 00-C9, have similarprofiles (Chart 3 and Chart 4).
CMBS SUPPORT IOS: BETTER THAN THEY SOUNDIn contrast, 2001 is an excellent vintage for WAC IOs.
With interest rates falling most of the year (Chart 1), thedifference between coupons on the collateral andcoupons on CMBS bonds is huge. The IO cannot only bestripped off the front and back tranches of a CMBS dealbut also off all of the tranches, including the mezzaninebonds—the best bonds in a deal from the perspective ofinterest rate protection (Chart 5).3 The difference is solarge that a good part of a deal’s profitability depends on
CMBS IOs: Vintage versus Structure (cont.)
200
180
160
140
120
100
80
60
40
20
0
AAA AAA AA A A- BBB BBB- Subs
Source: Wachovia Securities.
Chart 2: FUNB 00-C1 IO Components
150
125
100
75
50
25
0
AAA AAA AA A A- BBB BBB- Subs
Source: Wachovia Securities.
Chart 3: BSCMS 00-WF1 IO Components
180
160
140
120
100
80
60
40
20
0
AAA AAA AA A A- BBB BBB- Subs
Source: Wachovia Securities.
Chart 4: JPMC 00-C9 IO Components
Source: Wachovia Securities.
7.5%
7.0%
6.5%
6.0%
5.5%
5.0%
10-Y
ear S
wap
Rate
11/00 12/00 1/01 2/01 3/01 4/01 5/01 6/01 7/01 8/01 9/01 10/01
Chart 1: Historical 10-Year Swap Rates
250
200
150
100
50
0
AAA AAA AA A A- BBB+ BBB BBB- Subs
Source: Wachovia Securities.
Chart 5: FUBOA 2001-C1 IO Components
the execution of the WAC IO. To realize the maximumvalue from these fat IO strips, dealers have begun carvingup the WAC IO into two parts: a so-called PAC IO and asupport IO. The PAC IO is typically an 84-month IO,created from the mezzanine or middle bonds in the deal with the higher-rated tranches protecting them from default-induced prepayments and the lower-ratedtranches sheltering them from losses (Chart 6). Theresult is an incredibly stable IO class—perfect forinvestors looking for extra yield but concerned about thevolatility of a typical CMBS IO. This PAC IO is shownas the X2 class in Chart 6. The rest of the interest is usedto create the support IO (the X1 class, Chart 6.)
For anyone who has looked at CMOs (collateralizedmortgage obligations), the terms “support” or “companion”have poor connotations. However, notice anythinginteresting? The support IO, the X1 class of FUBOA 2001-C1, looks an awful lot like the barbelled WAC IO offFUNB 00-C1 (Chart 2). The different names notwith-standing, they are similar in structure and performance whenstressed with prepayment and default scenarios. Yet as ofthis writing, FUBOA 2001-C1 was being offered at 575 bpat 100 CPR, 25 bp more than the WAC IO FUNB 00-C1(550 bp at 100 CPR).
SIMILAR PERFORMANCE WHEN STRESSED WITHPREPAYMENT AND DEFAULT SCENARIOS
The more recent vintage support IOs and oldervintage WAC IOs look and perform similarly whenstressed with various prepayment and default scenarios.For example, if we stress FUNB 2000-C1 (the WAC IO)and FUBOA 2001-C1 X1 (the support IO) with 1 CDR-2 CDR, assuming a 35% severity rate and a 12-month lagto recovery, the yield of the support IO drops from8.9517% to 7.2325%, or 172 bp. The yield of the WAC IOdrops from 8.6478% to 7.0464%, or 160 bp. If we thenstress 2 CDR-3 CDR, the yields of both bonds drop by asimilar amount (176 bp for the support IO versus 189 bpfor the WAC IO). The performance of earlier vintage
CMBS IOs: Vintage versus Structure (cont.)
40 CMBS WORLD™
SM
250
200
150
100
50
0
AAA AAA AA A A- BBB+ BBB BBB- Subs
Source: Wachovia Securities.X 2 X 1
Chart 6: FUBOA 2001-C1 IO Components, Years 1–8
250
200
150
100
50
0
AAA AAA AA A A- BBB+ BBB BBB- Subs
Source: Wachovia Securities.X 2 X 1
Chart 10: FUBOA 2001-C1 IO Components, Years 9–10
1 CDR 2 CDR 3 CDRBase 12 Months, 12 Months, 12 Months,
Bond Price Case 35% 35% 35%
FUBOA 2001-C1 X1 575 bps at Yield 10.6269 8.9517 7.2325 5.4761100 CPY
(Support IO) 5:05 Avg Life 8.57 8.28 8.00 7.73
FUNB 2000-C1 IO 550 bps at Yield 10.1336 8.6478 7.0464 5.1599100 CPY
(WAC IO) 3:25 Avg Life 8.51 8.20 7.91 7.63
Note: Analysis as of October 5, 2001 – 1-year Treasuries 2.31%; 2-year Treasuries 2.77%; 5-yearTreasuries 3.74%; 10-year Treasuries 4.60%; and 30-year Treasuries 5.49%.
Source: Wachovia Securities
Chart 7: New Support IOs Offer Higher Yields and Similar Average Life Stability When Stressed with Defaults
Base 12-Month 36-MonthBond Price Case Extension Extension
FUBOA 2001-C1 X1 575 bps at 100 CPY Yield 10.6269 13.1695 16.0683
(Support IO) 5:05 Avg Life 8.57 9.47 11.19
FUNB 2000-C1 IO 550 bps at 100 CPY Yield 10.1336 11.3861 13.1245
(WAC IO) 3:25 Avg Life 8.51 9.36 11.00
Note: Analysis as of October 5, 2001 – 1-year Treasuries 2.31%; 2-year Treasuries 2.77%; 5-year Treasuries 3.74%; 10-year Treasuries 4.60%; and 30-year Treasuries 5.49%.
Source: Wachovia Securities
Chart 9: New Support IOs Offer Greater Upside When Loans Extend
BaseBond Price Case 0 CPY 100 CPY
FUBOA 2001-C1 X1 575 bps at 100 CPY Yield 10.6269 10.1695 10.0131
(Support IO) 5:05 Avg Life 8.57 8.57 8.40
FUNB 2000-C1 IO 550 bps at 100 CPY Yield 10.1336 10.1336 9.7332
(WAC IO) 3:25 Avg Life 8.51 8.51 8.25
Note: Analysis as of October 5, 2001 – 1-year Treasuries 2.31%; 2-year Treasuries 2.77%; 5-yearTreasuries 3.74%; 10-year Treasuries 4.60%; and 30-year Treasuries 5.49%.
Source: Wachovia Securities
Chart 8: New Support IOs Offer Higher Yields and Similar Average Life Stability When Stressed with Prepayments
WINTER 2002 41
WAC IOs and more recent vintage support IOs is similarwhen stressed with various CDR (constant default rate)levels with one important exception: the more recentvintage IO is 25 bp–30 bp cheaper in yield across mostscenarios. Moreover, other support IOs can trade as muchas 100 bp greater in yield versus other WAC IOs becauseof market misperceptions.
If we stress both IOs with prepayments the results aresimilar, although the WAC IO performs slightly better.For example, the yield of the support IO falls 61 bp to10.0131% when we stress the IO at 100 CPY (constantprepayment) (see Chart 8) and the yield of the WAC IOfalls 40 bp to 9.7332%.
SUPERIOR PERFORMANCE WHEN UNDERLYINGLOANS EXTEND
Besides offering a higher yield and similar risk profile,the recent vintage support IO offers significantly moreupside than the earlier vintage WAC IO should theunderlying loans in the deal extend (e.g., due to a loanworkout). If we allow 100% of the loans in both deals toextend 12 months, the yield of the support IO increases254 bp to 13.1695% versus an increase of 125 bp to11.3861% for the WAC IO (Chart 9). If we take theadditional scenario whereby the underlying loans in thedeals extend 36 months, the performance difference iseven more dramatic—a yield increase of 544 bp for thesupport IO versus 299 bp for the WAC IO.
This superior performance is due primarily to theinterest strip for the recent vintage support IO beinggreater (wider, or “fatter”) than the interest strip for theearlier vintage WAC IO. After 9-10 years, when the loanscould extend, X1, the support IO, is receiving theinterest strips from all the remaining tranches, becauseX2, the PAC IO, is gone after month 84. As shown inChart 10, these strips range from more than 50 bp toalmost 200 bp. In contrast, the interest strips for the 2000WAC IOs are thin (Chart 2). Because the coupon strip onthe support IO is so much greater than the coupon stripon the WAC IO, the interest cash flows increase muchmore as the length of time the principal is outstandingincreases. Thus, when the loans extend, because the
amount of extra interest paid is greater for the support IOthan for the WAC IO, the yield increases much more forthe support IO than for the WAC IO.
CONCLUSIONUnderstanding the interaction between structure, the
CMBS credit curve at issuance and the rate environmentduring the CMBS gestation period is key in determiningrelative value between different types of IOs withvarious vintages. Significant market misunderstanding ofmore recent vintage CMBS support IOs causes them totrade cheaply versus older WAC IOs. This analysis showsnot only that recent vintage CMBS support IOs havesimilar risk profiles to older vintage WAC IOs but alsothat they offer considerably more upside should theunderlying loans extend. Although there is somewhatbetter liquidity in WAC IOs than support IOs, this islargely due to market misperceptions about the two bondtypes. Finally, the collateral behind more recent vintageIOs tends to be more uniform and of superior quality tothe collateral backing earlier vintage IOs. ❑
Brian Lancaster is Managing Director and Scott Fuller is aVice President at Wachovia Securities, which is the trade nameunder which First Union Securities, Inc. conducts itsinvestment banking, institutional, and capital marketsbusinesses. This report is for your information only and is notan offer to sell, or a solicitation of an offer to buy, the securitiesor instruments mentioned. The information has been obtainedor derived from sources believed by us to be reliable, but we donot represent that it is accurate or complete. Any opinions orestimates contained in this information constitute our judgmentas of this date and are subject to change without notice.
1The time it takes to amass sufficient collateral to create a “largeenough” CMBS deal, usually a few months.
2The yields required by the market for the variously rated CMBSsecurities.
3Of course, the principal on these mezzanine bonds is at greaterrisk than the principal on the higher AAA rated classes
CMBS IOs: Vintage versus Structure (cont.)
