Non-call doesn’t necessarily mean price pain in AT1s
Private equity firms have reportedly been very active buying the debt tranches of collateralised loan obligations (CLOs) in recent weeks, a trend that has sparked an interesting question: why would these firms prefer to own bonds over physical assets in the current macro environment?
With margins and EBITDA multiples dropping in the corporate sector, it is not particularly hard to imagine PE investors favouring BB rated CLO bonds at a 15% yield in euros (and at a cash price of 75-80) over owning the actual companies that the loans backing these CLOs finance.
Bonds might seem an unfamiliar route for an industry that revolves around selling businesses and other assets for more than you paid for them (one ‘downside’ of bonds is you never get more than par back), but at today’s discount levels there is plenty of potential upside in CLOs. When you consider that at current yields, even going higher in the capital stack with investment grade CLO bonds (AAs now yield 6.5% in euros) investors can conceivably make double digit returns with a low degree of leverage (and locked in capital), the trade makes perfect sense to us.
Where this becomes even more interesting is in commercial real estate (CRE). With yields increasing, tenancy levels dropping and a recession looming, you have to wonder whether owning ‘bricks and mortar’ in a high inflation, rising rate environment stacks up versus owning real estate-backed debt. Just two weeks ago the CRE giant CBRE Group updated the valuations and rental yields it is seeing in the UK market (easily applied to all European markets), noting that landlords are now looking to get higher rental income from their tenants, which is no surprise given landlords’ cost of funding has increased significantly. Let’s not forget that wanting a higher rental income doesn’t mean (prospective) tenants are willing to pay higher rents, plus, if a lease has been locked in for five or 10 years then revising this rent is extremely difficult. CBRE now sees prime UK office rental yields at 3.5 to 4.5% in London and around 5.5% for regional cities. Warehouses and other logistics properties are still highly sought after, and thus rental yields in this sector are around 4% for prime and 6.25% for secondary. Retail unsurprisingly has the highest rental yields; supermarkets yield around 4.5%, while general retail is at 6.75% for prime locations and 8% for shopping centres.
It has to be said that these expected rental yields are from two weeks ago, and since then we have seen a recovery in Gilt yields after the resignations of Kwasi Kwarteng and then Liz Truss, so the real yields might now be slightly lower. CBRE reported UK commercial property valuations dropped by 5.1% in the UK in the third quarter, ranging from -2.3% for offices to -9.5% for industrial properties, though they also showed small (1.1%) rental increases. That means total returns in CRE were negative for the third quarter; they were far from alone since virtually every asset class had negative returns in Q3, but what stands out here is that in our view, the yields in CRE just don’t stack up versus what we’re seeing in the fixed income market.
If rental yields for prime offices are at 4.5% (taking the highest level) and yields on AAA rated CMBS bonds are at 6.5-7% (these are the very bonds that finance the most senior part of the mortgages on these properties, at around 30% loan-to-value), then in our view one of these has to be wrong. Yes, the AAA CMBS may be trading at a cash price in the low 90s and the best thing that can happen is getting back par, but for prime offices to make sense as the alternative trade, you would need to see either a significant increase in commercial property values or successful renegotiation of rents by management. With a recession looming and with central banks forced to hike rates to get inflation under control, we struggle to see that trade working in the next few years.
It is therefore no surprise to us that the strongest bid for European and UK CMBS recently has again come from private equity, which would typically own the properties outright. While CMBS bond spreads are wide due to the largest liquidity event that UK pension funds have seen for a very long time, commercial real estate valuations look very vulnerable.