Since the start of 2017, a number of opportunistic investors sought to profit from the expected demise of the physical retail sector, a trade which we and others dubbed the next “Big Short” – also known as the “Amazon crushes everyone” trade – and in which investors bought credit-default swaps against subordinate bonds in certain CMBX derivative indices that are tied to CMBS deals with healthy concentrations of loans against shopping malls and retail centers.
As CMBS advisory Trepp notes, the trade gained notoriety last February, when spreads for the BBB- and BB rated components of the indices went through a massive widening. They continued to widen at a somewhat steady clip until only recently. That alone indicates the trade, particularly if executed early, has paid off nicely.
CMBX consists of a group of indices that are each linked to a group of 25 CMBS conduit deals issued during a particular year. The indices are used as an indicator of the overall performance of the CRE market and enables investors to make bets on corresponding long and short positions.
Investors who expect deals in a specific index to incur losses can buy protection: they would pay a fixed-rate premium to a seller of protection who would bet against losses. If losses occur, the seller of protection would cover them. So, a short trade becomes most profitable when deals in an index suffer actual losses. It also becomes profitable in the event spreads widen, as they have.
Spreads Move Wider and Wider
The spread blowout in CMBX has been especially pronounced for the 6 and 7 series, which are tied to CMBS deals issued in 2012 and 2013. Those spreads have widened largely due to the perceived greater exposure to struggling mall properties and retail bankruptcies. The focus of the trade has been placed on junior bonds in the lower credit stack because the notes are typically the first to incur losses when distressed loans are liquidated or written off.
Compared to their tightest levels in late January, BBB and BB spreads for the two segments initially widened between 130 and 295 basis points, respectively, in just two months as word about the trade emerged. While the sell-off paused momentarily in April, spreads for the BBB- tranches of CMBX 6 and 7 resumed their climb by August. The spreads then peaked at year-to-date highs in early November that were 358 and 202 basis points wider, respectively, than their lows in January.
By the same token, spreads for the lower credit BB bonds in those same indices reached highs that were a staggering 499 and 254 basis points wider than their narrowest points roughly 10 months ago. During this devaluation period, the traded price pegged to the BBB and BB portions of CMBX 6 and 7 series were reduced by 10 to 17% as investors rushed to crowd the trade.
Prices and spreads for the derivative positions have since recouped some of their losses as the market has begun to catch on that the underlying bonds are being priced below their actual worth.
Broader Retail Worries Weigh on CMBX
It’s no secret that the retail landscape is in the midst of an unprecedented revolution. The cause of the blowout in CMBX spreads centers on the idea that the weak performance of certain retailers, particularly JCPenney, Sears, and Macy’s, would impact the properties they occupy. The three department store chains often anchor class-B and -C malls and have been shuttering stores by the dozens.
Such closures often trigger co-tenancy clauses for other in-line mall tenants, prompting them to downsize or vacate altogether. The thinking has been that properties, particularly those in secondary or tertiary markets, exposed to the three firms are at greater risk of default and losses. As such, those holding short positions in certain CMBX indices would receive a payout.
But has the bet paid off? Not quite. Retail loans are the most exposed property type for both the CMBX 6 and CMBX 7 indices with a 38.24% and 32.4% concentration, respectively. But only 1% of the remaining balance of retail assets has been marked as delinquent.
So far, only 40 retail loans in deals tied to the CMBX 6 and 7 series have paid off, and four incurred losses totaling $4.3 million. Each of those notes disposed was in a 6 series deal. No losses have been attributed to deals tied to CMBX 7. But the number of distressed retail mortgages will likely increase as they inch closer to their scheduled maturity dates and collateral performance continues to deteriorate.
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