This year’s narrow equity market has been a great example of how a broad index is not always perfectly representative of the constituents that make up that index. For example, the S&P 500 Index is composed of a number of different sectors with a large range of performance dispersion within the sectors. As a result, some sectors are likely overpriced while others represent significant value. Uncovering the opportunities and balancing the potential risk in markets like this requires a deep analysis beyond a broad index. Investors need to peel back the layers to identify favorable sectors and sub-sectors as they assess their investment potential within both equity and fixed income markets.
Market volatility often leads to opportunities as asset classes, sectors, and securities can become mispriced or overlooked. Investor fear tends to spread across all securities regardless of quality, which has certainly been the case within the commercial real estate market this year. As interest rates have spiked and we have seen a seemingly secular shift away from the office, commercial real estate as a whole has been hitting the news as the next shoe to drop. While this scenario is concerning for commercial real estate properties and those investors who concentrate in office buildings or retail, the commercial real estate sector’s realm is much broader in scope. Not only are there numerous commercial real estate sub-sectors, but there are also many investment vehicles that provide dedicated exposure to these sub-sectors creating an array of potential value opportunities for astute investors. One of the sub-sectors that we favor with multiple investment vehicles is commercial mortgage-backed securities (CMBS), which are bonds tied to the loans on commercial properties.
CMBS are similar to residential mortgage-backed securities where loans on property pass the interest and principal through to bond investors. Just like the traditional bond market sectors, most CMBS are rated by one of the rating agencies, are tradeable in the bond market, and priced daily. The CMBS market is represented by many different property classes including but not limited to apartments, hotels, office, industrial, and retail (Exhibit 1). Additionally, the CMBS market consists of both government agency and non-agency issued bonds just like the residential mortgage-backed securities sector.
With higher interest rates and declining occupancy rates, there have been many ratings downgrades in the CMBS market this year, which is not surprising as delinquency rates have increased for some property types.
According to the Mortgage Bankers Association, office and retail are seeing the bulk of the rises in delinquencies, while property types with more stable cash flows, such as multifamily and industrial, are doing well. At the same time, spreads have widened for CMBS, making the sector attractive relative to its ten-year average.
This scenario has led to volatility in the CMBS market and created opportunities for active managers that can add value through sector and security selection. With nearly 50% of the outstanding CMBS falling into the office and retail space, using an actively managed product for CMBS exposure can help mitigate risk. The flexibility of active bets within the portfolio allows for tilts to stronger performing sectors and securities that offer value. We believe the addition of actively managed CMBS exposure can help diversify a fixed income allocation and provide an attractive yield with less interest rate risk.
DISCLOSURES
Any forecasts, figures, opinions or investment techniques and strategies explained are Stringer Asset Management, LLC’s as of the date of publication. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect to error or omission is accepted. They are subject to change without reference or notification. The views contained herein are not be taken as an advice or a recommendation to buy or sell any investment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested.
Past performance and yield may not be a reliable guide to future performance. Current performance may be higher or lower than the performance quoted.
The securities identified and described may not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable.
Data is provided by various sources and prepared by Stringer Asset Management, LLC and has not been verified or audited by an independent accountant.
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